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University of Southern California Dissertations and Theses
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Hospital conversions: The California experience
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Hospital conversions: The California experience
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INFORMATION TO USERS This manuscript has been reproduced from the microfilm master. U M I films the text directly from the original or copy submitted. Thus, some thesis and dissertation copies are in typewriter face, while others may be from any type of computer printer. The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bieedthrough, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send U M I a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note w ill indicate the deletion. Oversize materials (e.g., maps, drawings, charts) are reproduced by sectioning the original, beginning at the upper left-hand comer and continuing from left to right in equal sections with small overlaps. ProQuest Information and Learning 300 North Zeeb Road, Ann Arbor, M l 48106-1346 USA 800-521-0600 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. HOSPITAL CONVERSIONS: THE CALIFORNIA EXPERIENCE Copyright 2001 by Richard George Heller A Dissertation Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment o f the Requirements for the Degree DOCTOR OF PHILOSOPHY (PUBLIC ADMINISTRATION) December 2001 Richard George Heller Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. U M I Number 3065794 Copyright 2001 by Heller, Richard George A ll rights reserved. UMI’ U M I Microform 3065794 Copyright 2002 by ProQuest Information and Learning Company. A ll rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor. M l 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UNIVERSITY OF SOUTHERN CALIFORNIA The Graduate School University Park L O S ANGELES, CALIFORNIA 90089-1695 This dissertation , w ritten b y RICHARD GEORGE HELLER Under th e direction o f Ai.su D issertation Com m ittee, and approved b y a ll its members, has been presen ted to and accepted b y The Graduate School, in partial fulfillm ent o f requirem ents fo r th e degree o f DOCTOR OF PHILOSOPHY De a n o f G raduat e Scudks D a t e December 17. 2001 DISSERTATION COMMI TTEE Chai r per s on Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Dedication To my parents, William S. & Sylvia M. Heller, and my wife. Velvet Satin Heller. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Acknow ledgem ents ■ The assistance of H. Chester Horn, Jr., Deputy Attorney General, State of California, is gratefully acknowledged. ■ I am also grateful to the members of my Dissertation Committee, especially my chair, Professor James M. Ferris. iii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. T able o f C o n t e n t s Dedication...................................................................................................................... ii Acknowledgements...................................................................................................... iii List of T ables................................................................................................................ ix Abstract........................................................................................................................ xii Chapter 1 I n t r o d u c t io n ...............____ .............— .......____ ........ 1 1.1 B a c k g r o u n d........................................................................................ l 1.2 C o n tex tu a l O v er v ie w .................................................................... 3 1.3 T he P u blic In t e r e st..........................................................................6 1.4 C a lifo r n ia ’s Regulatory Sc h em a ............................................11 1.5 Pr io r Stu d ie s.....................................................................................15 1.6 D isser ta tio n Purpose a n d O b jec tiv es..................................... 18 1.7 O r g a n iza tio n of the Fo llo w in g Ch a pt e r s........................... 2 1 En d n o tes fo r Chapter l ......................................................................... 22 Chapter 2 T h e B u s in e s s E n t e r p r is e V a l u a t io n o f H o s p i t a l s _______________________________________________30 2.1 In tr o d u c tio n....................................................................................30 iv Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.2 T he Sta tu to r y St a n d a r d .............................................................30 2.3 T he T h eo r y o f Bu sin ess Enterprise V a l u a t io n ...................33 2.3.1 The Cost Approach............................................................................ 34 2.3.2 The Market Approach........................................................................ 35 2.3.2-1 The Comparable Transactions Approach______________________________ 35 23.23 The Comparable Companies Approach_______________________________ 42 2.3.3 The Income (Discounted Cash Flow) Approach..................................44 2.33.1 Operational Definition of Cash Flows________________________________45 2332 Use of Historical Cash Flows versus Future Cash Flows--------------------------- 47 2 3 3 3 Predicting Terminal or Residual Value_______________________________ 49 233.4 Determining the Applicable Discount Rate____________________________ 50 2 3 3 3 Illustration of DCF Analysis_______________________________________5 1 2.4 C a lifo r n ia Va lu a tio n C ase Studies......................................... 56 2.5 C o n c l u sio n s.......................................................................................57 En d n o tes fo r Ch a pter 2 ......................................................................... 63 Chapter 3 U s e o f C h a r it a b l e P r o c e e d s 71 3.1 In tr o d u c tio n......................................................................................71 3.2 Ho spita l C o n v ersio n Endow m ents...........................................72 3.3 W ho Sh o u ld R ec eiv e th e Proceeds? ........................................ 76 3.3.1 Transfer o f Proceeds to Government................................................... 77 3.3.2 Transfer o f Proceeds to Charitable Organizations............................. 80 333.1 Section 501(cK3) Organizations------------------------------------------------------ 85 3322 Section 501(cX4) Organizations------------------------------------------------------ 88 3323 Public Policy Recommendations----------------------------------------------------- 89 3.4 W ho Sh o u ld M an a g e th e Proceeds? .......................................91 3.4.1 Corporate Governance: The Board o f D irectors................................93 3.4.2 The Agency Costs o f Directors........................................................... 95 3.4.3 Composition and Selection o f the Board............................................. 96 3.4.4 Policy Recommendations.................................................................. 101 3.5 H ow Sh o u ld th e Co n v ersio n or Sa les Pr o c e e d s Be Use d? ..............................................................................................104 V Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.5.1 Permissive Charitable Purposes..................................................... 105 3.5.2 Establishing Use Standards............................................................. 109 3.5.2.1 Queen o f Angels—Hollywood Presbyterian Medical Center--------------------- 1 1 1 3522 Riverside Community Hospital------------------------------------------------------ 113 3523 Normative Considerations________________________________________115 3.5.3 Implementation and Compliance.......................................................121 3.5.4 Policy Recommendations.................................................................../25 3.6 Sum m ary a n d C o n c l u sio n s........................................................127 Endnotes fo r C h a pter 3 ........................................................................131 Chapter 4 R e g u l a t o r y I s s u e s in H o s p it a l C o n v e r s io n s 1 4 3 4.1 Ov e r v ie w ...........................................................................................143 4.2 The Cu r r en t Sta te of Ho spit a l C onversion Re g u l a t io n .........................................................................................145 4.2.1 The Attorney General’ s Regulatory Jurisdiction...............................146 4.2.2 The Internal Revenue Service’ s Regulatory Jurisdiction.................. 152 4.3 Reg u la to ry Im plica tio n s fr o m the Hospita l Co n v ersio n C a se St u d ie s..............................................................155 4.3.1 Improving Public Access to Hospital Information............................. 156 4.3.2 Improving Financial Disclosure and Accountability Requirements.... 158 4.3.3 Improving Public Participation in the Conversion Process................163 4.3.4 The Attorney General’ s Use o f Appraisals....................................... 165 4.3.5 Use o f Conversion Proceeds............................................................ 168 4.4 Public Po l ic y Ex ten sio n s o f Ex istin g La w ____________ 171 4.4.1 Bringing Sunshine to the Board.......................................................173 4.4.2 Placing Public Members on the Board............................................. 183 4.4.3 Improving Regulatory Oversight o f Charitable Organizations..........187 4.4.4 Providing Limited Standing to Charitable Beneficiaries...................189 4.4.5 Using Audited Self-Regulation.........................................................192 4.5 Co n c l u sio n s..................................................................................... 194 Endnotes fo r C h a pter 4 ........................................................................198 vi Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter § C o n c l u s io n s 210 5.1 In tro d u ctio n...................................................................................210 5 2 Principal Fin d in g s of the C a se Stu d ie s.................................213 5.3 C harting a P a th to Re f o r m ...................................................... 218 5.4 Th e Lesson o f Reg u la tio n......................................................... 224 Endn o tes for Ch a pt e r 5 .......................................................................226 B ib l i o g r a p h y _____________________________________________ 230 A p p e n d ic e s _________________________________________________253 A ppen d ix A: Tec h n ic a l Appendix to C h apter 1 — M echanics a n d Leg a l Is s u e s...................................................... 254 A. I Basic M echanics................................................................................255 A.2 Sale o f Assets......................................................................................256 A.3 Joint Venture Formation.................................................................... 260 A.4 Tax Consequences.............................................................................. 264 Endnotes fo r Appendix A ............................................................................ 265 A ppen d ix B: Tec h n ic a l App e n d k to C h a pter 2— Hospita l Va l u a t io n s..................................................................... 267 B. I Case Study Document Sources............................................................ 268 B.2 Overview............................................................................................ 268 B.3 Discrete Time Modeling......................................................................269 B.4 Continuous-Time Modeling................................................................. 274 B.5 Case Studies on Hospital Valuation.....................................................276 B.5.1 Good Samaritan Health System____________________________________ 276 B.5.2 Centinela Valley Health Services___________________________________ 285 B.5J Pacific Hospital o f Long Beach____________________________________ 294 B.5.4 United Western Medical Centers____________________________________297 B.5.5 Queen of Angeles—Hollywood Presbyterian Medical Center.______________ 301 B.5.6 Riverside Community Hospital_____________________________________ 309 B J.7 Sharp Healthcare---------------------------------------------------------------------- 317 vii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. B.6 Limitations........................................................................................ 326 Endnotes fo r Appendix B.............................................................................329 A ppen d ix C: Technical A ppendix to C h a pte r 3— Use o f C ha rita ble Pr o c c ee d s.............................................................334 C.I Document Sources............................................................................. 335 C.2 Overview........................................................................................... 335 C.2.1 Good Samaritan Health System____________________________________ 337 C22. Cenrinela Valley Health Services__________________________________ 342 C.23 Pacific Hospital of Long Beach____________________________________ 344 C-2.4 United Western Medical Centers___________________________________ 345 C 3 . . 5 Queen of Angels_______________________________________________ 347 C2. 6 Riverside Community Hospital_____________________________________351 C.3 Comments and Conclusion.................................................................353 Endnotes fo r Appendix C.............................................................................356 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. List o f Ta bles Page Table 1: Summary of Hospital Transactions............................................................5 Table 2: California Hospital Conversions...............................................................20 Table 3: Nonprofit Hospital Acquisition Statistics.................................................37 Table 4: Application of Metrics to Riverside Community Hospital........................39 Table 5: Historic EBITDA Multipliers.................................................................. 41 Table 6: Selected Corporate Statistics....................................................................43 Table 7: Implicit Valuation of Riverside Community Hospital.............................. 43 Table 8: Riverside Community Hospital................................................................ 52 Table 9: Assets of Charitable Organizations Funded by Nationwide Hospital Conversions.......................................................... 73 Table 10: Assets of Charitable Organizations Funded by California Hospital Conversions............................................................................. 74 Table 11: Good Samaritan Hospital Range of Values........................................... 277 Table 12: Good Samaritan Financial Data (Abridged)..........................................277 Table 13: Good Samaritan Discount and Growth Factor Sensitivity Analysis..............................................................................................279 ix Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table-14: Weighted Average of Possible Valuation—Methods Applied to Good Samaritan_______________________________ 281 Table 15: Good Samaritan Cash Flow Functions_________________________ 282 Table 16: Centinela Hospital’s Projected Cash Flows_____________________ 287 Table 17: Summary of Selected Valuation Results for Centinela Hospital_______________________________________________ 290 Table 18: Morgan Stanley’s Free Cash Flows for Centinela Hospital.....................292 Table 19: Pacific Hospital’s EBIDTA Calculations...............................................295 Table 20: Purchase Bids for United Western Medical Centers................................298 Table 21 Valuation Sensitivity Matrix................................................................. 299 Table 22: Pacific Hospital’s EBITDA Calculations...............................................300 Table 23: Queen of Angel’s Cash Flow Projections...............................................303 Table 24: Valuation Sensitivity Matrix................................................................. 304 Table 25: Queen of Angels’ Actual Operating Cash Flows.................................... 305 Table 26: Queen of Angels’ EBITDA..................................................................306 Table 27: Management’s Aggressive Free Cash Flows---------------------- 308 Table 28: Summary of Valuation Methods for Riverside Community Hospital............................................................................................... 311 Table 29: Discount and Growth Rate Sensitivity Analysis................ 313 Table 30: Selected Financial Data for Riverside Community Hospital............................................................................................... 314 x Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 31: Determination of EBITDA for Riverside Community Hospital_______________________________________________ 315 Table 32: Management’s Projected Post-Acquisition Cash Flows-------------------316 Table 33: Sharp Valuation Estimates-------------------------------------------------- 318 Table 34: Sharp’ s Cash Flows .......................................................................... 319 Table 35: Sensitivity Analysis Using Shattuck Hammond Data______________ 321 Table 36: Sensitivity Analysis Using Deloitte & Touche Data.............................. 322 Table 37: Shattuck Hammond’s Projected Free Cash Flows................................. 324 xi Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A bstract Prior to 1990, there were relatively few sales of nonprofit or charitable community hospitals to large “for-profit” hospital chains. During the 1990s, so-called hospital conversion transactions increased in number, and several consumer advocacy groups demanded more stringent government oversight to protect assets held in charitable trust In 1996, California enacted legislation to regulate nonprofit hospital sales. This legislation expanded existing law by giving the California Attorney General the discretion to negotiate and structure hospital conversions to better protect the public interest Before a nonprofit community hospital is sold, the California Attorney General must approve the proposed sales price and the form of economic consideration. Accordingly, the principal research question is whether the Attorney General’s transactional review process has permitted the selling nonprofit hospital corporations to receive the equivalent of fair market value for their hospital assets. Although flecked with errors, in each of six California hospital conversion transactions that occurred between the years 199S and 1997, the sales price was found to be within a reasonable range of value using standard business valuation methodologies and practices. When a nonprofit community hospital is sold, the California Attorney General must approve the use of the sales or conversion proceeds. A secondary research question is whether the Attorney General has sought to impose special restrictions on use of hospital xii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. sales proceeds by conversion foundations. In the conversion transactions that were examined, the restrictions were considerable, there was little or no public participation in the expenditure decision-making process, and die directors of die conversion foundations were not allowed to use the sales proceeds to fund a variety of community health and welfare benefits. In light of the California Attorney General’s involvement in the hospital conversion process, the final research question is whether additional regulatory recommendations are prudent and appropriate to protect the public interest The principal finding is that the California Attorney General’s charities database, which allows interested consumer and community groups to track the use of sales proceeds by conversion foundations, is missing important disclosure information. Dissertation Committee James M. Ferris, PhJ)., Committee Chair Professor, School of Policy. Planning and D e v e lo p m e n t. USC Elizabeth A. Graddy, PhJ)., Committee Member Associate Professor, School of Policy, Planning and Development, USC Robert J . Sacker, PhJ)., Committee Member Professor, Department of Mathematics, USC Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. C h a p t e r 1 Introductio n 1.1 Background This dissertation is about the special asset valuation, charitable use considerations, and regulatory issues that are pertinent to hospital acquisition or purchase transactions occurring between “for-profit” publicly-held hospital business entities such as Columbia, Tenet, and Quorum, and “not-for-profit” non-government community hospitals.1 Although “mixed” sector acquisitive transactions are comparatively rare, they are of special interest to the public and regulatory authorities because they tend to present opportunities for unjust private sector inurement or enrichment as well as opportunities for the mismanagement of monies held in public trust Whether the participants are private “for-profit” companies or public “for-profit” companies (i.e., companies listed on an established stock exchange), mergers and acquisitions are rather common business activities and it is common business knowledge that they usually entail corporate law issues, tax issues, anti-trust issues, and securities law issues. The managements of both parties to a corporate marriage must master a large body of practical knowledge and exercise legal and financial due diligence for the benefit of their respective stockholders.2 The business press (e.g., The Wall Street Journal. Fortune. 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Forbes, Business Week, Investor's Business Daily, etc.) is usually chock full o f stories about mergers and acquisitions that occur in the private sector and, when things go wrong, divestitures.3 Thus, when one large “for-profit” hospital chain decides to purchase another “for-profit” hospital chain, die corporate “marriage” announcement is usually a topic for the business press and rarely is there any public commotion or remonstration. When, however, the acquiring or purchasing company is a “for-profit” business organization and the acquired or target company is a “non-profit,” tax-exempt charitable organization,4 two principal considerations come into play. First, the laws of some states may prohibit a “non-profit” or “not-for-profit” tax-exempt, charitable corporation from selling or otherwise transferring all or substantially all of its assets to a “for-profit” corporation under any circumstances.5 Second, if an asset sale or transfer is permissible under state law, then under both state and federal law the sales proceeds must remain in charitable solution indefinitely for the public’s use and benefit6 This requirement exists because, under both state and federal law, the hallmark of a “charitable” tax-exempt organization or corporation is the permanent exclusive, and irrevocable dedication of assets to charitable use and purposes for the public’s benefit7 The “irrevocable dedication of assets” requirement entails two important consequences. First when the operating assets of a community non-profit charitable hospital are sold, the selling hospital’s assets must be replaced with cash or securities (sales proceeds) of equivalent fair market value. Second, the selling non-profit charitable organization (or its successor-in-interest) must retain those proceeds in charitable solution and use them to further the so-called public interest, usually under terms and conditions established by either the State Attorney General or a court of competent jurisdiction. 2 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Although state laws vary, and this variance has been the cause of public concern, since 1997 the California Attorney General has had broad statutory authority to deal with questions of asset valuation and make “public interest’ ' determinations in transactions involving hospitals and other health facilities.* Acting in the public interest, he may even prohibit the proposed transaction altogether. 1.2 Contextual Overview The corporate transformation of American medicine began in earnest in the 1960s and 1970s, in large part because o f permissive government payments due to the passage of Medicare and Medicaid legislation during the Johnson Administration.9 During the 1970s and 1980s, hospitals became lucrative businesses and large “for-profit” hospital chains such as Columbia/HCA, Quorum Health Resources, Tenet Healthcare, and OrNda HealthCorp emerged through extensive private-sector merger and acquisition activity.1 0 These large chains actively pursued rapid expansion strategies and, as a result, they enjoyed substantial asset and net patient revenue growth.1 1 By 1997, the total revenue of Columbia/HCA, the nation’s largest “for-profit” hospital chain, exceeded SI8 billion.1 2 In the late 1980s and throughout most of the 1990s, however, there was a dearth of acquisition opportunities in the “for-profit” sector. The shortage of suitable “for-profit” acquisition candidates prompted Columbia/HCA and the other large hospital chains to examine acquisition targets in the “non-profit” sector.1 3 Until 1998, when Columbia became embroiled in a massive Medicare fraud investigation, Columbia’s management aggressively pursued the purchase o f financially distressed “non-profit” or “not-for-profit” 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. community hospitals.1 4 In fact, shortly before its legal troubles began Columbia was in die process of completing or negotiating more than one hundred acquisitions or joint ventures with non-profit hospitals.1 3 The acquisitions of non-profit community hospitals by Columbia/HCA and other “for profit” hospital chains have raised several concerns. Some policymakers and consumer groups have complained that as a result of such acquisitions charity patients will be left by the wayside, cost-cutting efforts will reduce both the quality and quantity of patient care, skilled medical and nursing personnel will be replaced by less skilled personnel, and prices for medical services and procedures will rise due to the concentration of market (monopoly) power.1 6 This is, of course, an empirical question. Another set of concerns is largely financial. The allegation is that Columbia/HCA and the other large “for-profit” hospital chains have reaped substantial financial “windfalls” at the public's expense.1 7 Briefly, the claim is that because in most cases the management of the acquired non-profit hospital does not know the proper value of the hospital's operating assets, the acquisition is usually a “bargain purchase” for the acquiring “for-profit” corporation and a corresponding financial detriment to the community.1 * This too is an empirical question. It is against the backdrop of these concerns that several organizations, including Consumers Union,1 9 the publisher o f Consumer Reports, the Project Hope Center for Health Affairs,2 0 the publisher of Health Affairs, and die Volunteer Trustees Foundation for Research and Education2 1 have sponsored writings and workshops about a growing phenomenon: the “conversion” of “nonprofit public benefit” hospital corporations to “private” or “investor-owned” status.2 2 The acquisition of a “non-profit” hospital by a 4 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. “for-profit’ ' hospital is often referred to as a “conversion” because the non-profit hospital’s operating assets become an integral part of the existing hospital operations of die “for- profit” acquiring business entity; i.e., the operating assets are deemed to “convert” to “for- profit” status from “non-profit” status. The advocacy of the consumer interest groups notwithstanding, the amount of business and consumer publicity surrounding hospital conversion activity may be disproportionate to the number o f actual transactions: it appears that only one percent of all nonprofit hospitals may have converted to “for-profit” status.2 3 This figure, however, probably ignores hospital beds. To put the matter into perspective, the following Table 1 summarizes hospital acquisition activity for the years 1994 through 1997, a period of considerable hospital conversion activity: Table 1: Summary of Hospital Transactions Sum m ary of Transactions (Number of Hospitals) 1 9 9 4 1 9 9 5 1 9 9 6 19 9 7 Privately owned “for-profit" hospital targets 45 1 8 2 7 9 Publicly owned “for-profit” hospital targets 1 9 7 28 1 0 5 29 “ Non-profit” hospital targets 7 3 226 1 9 1 238 Total for all hospital targets 315 272 323 276 Average target purchase price (in millions) $2853 $202.1 $141.9 $57.7 Total number of target hospital beds 66,345 65,438 66,557 56,845 Average number of beds per hospital target 2 1 1 2 4 1 206 206 Non-profit “public benefit" hospitals2 4 3,139 3,092 3,045 3,000 Private “for-profit" hospitals 719 752 759 797 Total non-government community hospitals 3,858 3,844 3,804 3,797 Total non-govemment community hospital beds 738,000 716,000 707,000 706,000 Source: Irving Levin Associates, Inc_ The Hospital Acquisition Report, 4* ed. (New Canaan, CT: Irving Levin Associates, Inc., 1998), charts 6,8,9, & 1 0 . 5 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The actual number of nonprofit and “for-profit’ ' hospital beds involved in merger and acquisition activity appears to be small in relation to the total number of non government “for-profit’ ’ and “non-profit” community hospitals beds. For example, in 1994 there were 31S hospital transactions involving 66,345 hospital beds, but there were 3,858 non-government community hospitals in existence with 738,000 beds. Thus, for that year less than 10 percent of the nation’s total non-government community hospital beds were affected by merger and acquisition activity. Similar results hold for the years 1995 through 1997. On the one hand, perhaps this is why some academics believe that published articles and reports may have produced a problem that does not exist2 3 On the other hand, there is a possibility of transactional undercounting because, depending upon state law and the size of the non-profit target hospital, some acquisitive transactions may not have been reported.2 6 13 The Public Interest The public interest in hospital conversions stems from the generous public subsidies accorded to nonprofit charitable community hospitals through federal and state laws, especially the tax codes. Because of government subsidization, the assets of a nonprofit charitable community hospital are required to remain available for “public use” indefinitely. Thus, when a nonprofit charitable hospital is sold to a “for-profit” purchaser, the purchase monies must remain in “charitable solution” and be put to a related charitable use. If the price is too low, the “for-profit” purchaser will necessarily receive a bargain at Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the public’s expense. Several egregious examples have helped to fuel die passions of healthcare advocates and reformers. In California, the best-known case of unjust private enrichment involved neither a hospital nor a hospital chain but Family Health Program, Inc. (FPH), a California nonprofit health maintenance organization or HMO.2 7 Before November 198S, FHP was a California nonprofit tax-exempt HMO based in Fountain Valley, California. In November 1985, FHP sought to convert from a nonprofit to a “for-profit” corporation under rules and regulations promulgated by California’s Department of Corporations, the exclusive regulatory agency. The purpose of the conversion was to enable FHP’s founder and various board members and officers (corporate “insiders”) to effect a public offering o f FHP’s common stock. But first, an amount equal to the net asset value o f FHP would have to be contributed to a newly established charitable trust because FHP was a non-profit tax-exempt corporation, the assets of which had been irrevocably dedicated to charitable use under federal and state law. At the time of the proposed conversion, FHP’s insiders retained the public accounting firm of Ernst & Whinney (now Ernst & Young LLP) to value FHP’s net assets and determine the amount of the required charitable set-aside. With certain adjustments, Ernst & Whirmey’s valuation of approximately S36 million was based upon die net book value of FHP’s assets. FHP’s operating cash flows were considered but rejected because, according to the accountants, die resultant valuation figure would have been even lower. Upon conversion, the newly established charitable trust was to receive $7.2 million cash and a 10-year, 10% promissory note for the $28.8 million balance. Thus, the Department Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of Corporations was willing to permit FHP’s insiders to purchase FHP’s operating assets in exchange for a $36 million charitable contribution. A competitor. Maxicare Health Plan Inc., a “for-profit” public company, immediately challenged the conversion by offering to pay $50 million for the same assets. This offer would have resulted in $50 million being permanently set aside for charitable purposes—$14 million more than that offered by FHP’s insiders for the same operating assets. If Maxicare’s asset valuation were correct, the FHP insiders as a group would have made a $14 million hidden profit the insiders would be purchasing a $50 million company for only $36 million. Maxicare’s allegations of fraud and breach of charitable trust triggered considerable controversy and a special hearing by the California Assembly Committee on Finance and Insurance.2 8 Chaired by Assemblyman Alister McAlister, the December 4, 1986 hearing revealed that FHP’s initial valuation analysis was only $13.5 million but that a subsequent analysis (only a few months later) demonstrated FHP’s net assets to be worth $21.5 million. According to the hearing transcript, Ernst & Whinney considered three of the “accepted methods” of business valuation (adjusted book value, capitalized historical earnings, and discounted cash flow) but finally used the “adjusted book value” method because it yielded the highest value for FHP’s net assets—$36 million. Ultimately the Department of Corporations agreed to a valuation of approximately $38 million, but this was still $12 million less than Maxicare was prepared to pay for the same assets.2 9 Although the California Attorney General subsequently brought actions against FHP’s founder and insiders for fraud and breach of fiduciary duty, and against FHP’s accountants, Ernst & Whinney, for improper asset valuation, the California Court of 8 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Appeals ruled in FHP’s favor.3 0 The case against the insiders and FHP’s former management was dismissed on purely technical grounds: in the 1970s, the California Legislature had transferred oversight responsibilities for health service plans (HMOs) to the Commissioner of Corporations from the Attorney General's office. Since die Commissioner and the Department of Corporations thought that die FHP conversion arrangement was satisfactory, there was, in effect, no valid reason for the Attorney General’s complaint and attempted intervention, Maxicare’s willingness to pay S12 million more for the same assets notwithstanding. FHP’s conversion and its resultant public scrutiny did not escape the attention of various consumer groups. The same fundamental public policy issue would be at stake in hospital conversions: determining the proper amount of the charitable set-aside for the public’s benefit Nonprofit hospitals were subject to regulation by the Attorney General, who was determined not to allow an asset valuation debacle to occur on his watch. In other states, the public interest was similarly affected and advocacy groups sounded the alarm. An especially egregious example of an ‘ insider7 ’ asset sale is the case of the Anclote Psychiatric Center (APC), a non-profit, tax-exempt charitable psychiatric hospital located in Tarpon Springs, Florida. In 1983, APC’s founder and insiders sold die corporation’s non-profit hospital (its business and operating assets) to Anclote Manor Hospital (AMH), a newly formed "for-profit” Florida corporation that they controlled, for approximately $63 million. Less than two years later, in 1985, AMH resold the hospital to a "for-profit” public company, American Medical International, for approximately $29.5 million—representing a profit of $232 million to APC’s founder and insiders. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A disgruntled physician-employee, who also happened to be APC’s medical director, notified the Florida Attorney General's office and sued APC’s insiders and directors for breach of fiduciary duty and charitable trust Acting in the public interest the Attorney General sought to compel APC’s founder and insiders to disgorge their profits and return them to the state for charitable use. Unfortunately, in 1987 a Florida trial court ruled that Florida law provided no effective remedy. Shortly thereafter, the Florida Legislature amended the relevant corporation statutes to permit the Attorney General to recover improper profits in similar situations. The legislature, however, acted too late and, in 1989, a Florida appellate court upheld the trial court’s decision. The appellate court declined to apply the new statute to APC’s founder and insiders for (apparently) ex post facto policy reasons. As a result, APC’s founder and insiders, through AMH, their controlled corporation, were permitted to retain their $23.2 million windfall.3 1 Another example is the 1981 sale of S t Charles General Hospital, a tax-exempt non-profit charitable hospital situated in New Orleans, Louisiana, to a “for-profit” subsidiary of National Medical Enterprises, Inc. (NME), then a New York Stock Exchange listed company, and now part of Tenet Healthcare Corporation, for $12.6 million. A physician-director alleged that the $12.6 million sales price had been deliberately understated by $5 million and that NME had secretly agreed to purchase three other healthcare companies, each of which was essentially worthless, from certain St Charles’ board members in order to make up the difference. In effect some of the directors of the selling non-profit hospital had agreed to sell their votes in exchange for secret compensation. 10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. It is not clear why the- suit alleging breach of charitable trust and fiduciary duty was brought by the whistle-blower in 1990, some nine years after the sale. Fortunately for die public interest, the Supreme Court of Louisiana ruled that the complaint was not time- barred because the applicable statute of limitations was ten years, and it also concluded that the whistle-blower had made sufficient allegations to state a statutory cause of action for breach of fiduciary duty.3 2 As a result of these and similar cases, various consumer advocacy groups pressed their respective state attorneys general for responsible oversight and new legislation to prevent unjust enrichment and private inurement In 1996, California was among the first to enact specific hospital conversion legislation. The legislation became effective for conversion transactions occurring after December 31, 1996. 1.4 California’s Regulatory Schema Since 1980, and perhaps earlier, California nonprofit public benefit corporations, including non-profit hospitals, have been permitted to sell or otherwise dispose of all (or substantially all) of their assets in commercial transactions upon giving written notice to the Attorney General at least twenty days before the closing date of the transaction (the “general statute”)-3 3 During the 1990s, and pursuant to the general statute, the Attorney General scrutinized the larger hospital conversion transactions for commercial reasonableness, including those listed in Table 2, supra. Unfortunately, in the absence of a breach of a charitable trust there was nothing the Attorney General could do to modify or prevent a hospital conversion transaction because 11 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. he lacked specific statutory authority to do so.3 4 Moreover, a court was powerless to rescind the transaction or enjoin the performance of the hospital sales contract unless it would be “equitable to do so.” 3 5 Given die lack of specific statutory guidance for dealing with hospital asset sales, it is not surprising that there appear to be no judicial decisions or opinions of the Attorney General involving asset sales by California nonprofit public benefit corporations under the general statute.3 6 In 19%, die regulatory landscape changed. Supported by the California Attorney General and various special interest groups, including Consumers Union, publisher of Consumer Reports, and the California Medical Association, the California Assembly held hearings on proposed legislation designed to provide greater oversight and regulatory authority over the sale of assets belonging to California nonprofit “health facilities," including general acute care hospitals, acute psychiatric hospitals, special hospitals, and skilled nursing facilities.3 7 According to the Assembly committee’s report, hospital conversions will continue to occur in California as more nonprofit hospitals lose their economic viability due to reductions in health care service rates and Medi-Cal reimbursements to providers. The committee report expressly acknowledged that [T]he reduction in rates has caused the non-profit hospitals to face a serious financial dilemma. One recourse is to close down operations or turn to other sources of capital, such as those offered by investor-owned, for-profit corporations. (4)3 ® On September 30, 19%, Governor Pete Wilson approved Assembly Bill No. 3101 thereby giving die Attorney General broad authority to regulate hospital conversions in California. Under this legislation, effective for conversions occurring on or after January 1, 1997, die Attorney General must be notified whenever a nonprofit public benefit 12 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospital corporation desires to sell or otherwise dispose of a ‘ ‘material amount” of its assets to a “for-profit” corporation.3 9 The essential features of die regulatory schemata are: 1 . The sale of hospital or other “health facility” assets by a California nonprofit public benefit corporation to any for-profit corporation now requires the Attorney General’s written consent As a condition to granting approval, the Attorney General may impose additional transactional requirements in order to promote and protect the public interest4 0 2. Before consenting to the sale or other disposition of hospital assets, the Attorney General must hold one or more public meetings in the county in which the hospital or health facility is located.4 1 This requirement is designed to allow the community to participate in the decision-making process. 3. In exercising discretion to consent to, impose additional requirements, or reject the proposed sales transaction, the Attorney General may consider any factors that he or she deems relevant For example, the Attorney General may consider (1) whether or not the terms of the transaction (including the asset sales price and the interest rate on any purchase money indebtedness) are “fair and reasonable” to the selling nonprofit public benefit corporation, (2) die extent to which the sales proceeds from the transaction will be put to charitable use, and (3) the 1 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. impact of the transaction on the availability o f health care services to the affected community.4 2 4. Although no outside review is required, the Attorney General may enlist the services of outside experts and consultants to assist him or her in reviewing die proposed transaction. The cost of this review is to be home by the nonprofit public benefit corporation. In enacting legislation to regulate hospital conversions the California Legislature specifically found and declared that the public is the beneficiary of the trust on which charitable, nonprofit hospital corporations and other incorporated health facilities hold their assets and that to protect the public interest the Attorney General must be given broad, discretionary authority to regulate hospital conversion transactions.4 3 The enabling statute specifically authorizes the Attorney General to adopt regulations to implement the new law.4 4 Subsequent to the enactment of Assembly Bill No. 3101, and pursuant to the Attorney General’s permitted regulatory authority under the newly enacted statute, the Attorney General promulgated a substantive review protocol for the purpose of providing hospital conversion guidelines to attorneys and auditors within the Attorney General’s Charitable Trust Section.4 5 This protocol has seven specific components, the three most important of which (for purposes of this dissertation) are the valuation of the acquired or selling hospital as a “going business concern,” the extent to which die proposed sale of assets or the conversion will benefit die public, and whether or not sales or conversion proceeds will be put to proper charitable use.4 6 1 4 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Following California’s legislative experience, in 1998 the National Association of Attorneys General (“NAAG”) issued draft model legislation to regulate hospital conversions in all fifty states. The NAAG’s model legislation, which is designed to eliminate the valuation abuses that have preoccupied policymakers and critics of the hospital conversion process, largely follows California’s regulatory approach. As more states enact hospital conversion legislation to protect the public interest and provide administrative oversight, 4 7 the problems that brought hospital conversions to the public’s attention are likely to diminish and, consequently, the public’s interest in the conversion process is likely to fade.4 8 1.5 Prior Studies Several prior studies have commented upon hospital conversions and the perceived financial windfall that has accrued to the acquiring “for-profit” hospital chains. Some of the studies are qualitative, some are quantitative, and the conclusions appear to be mixed. There is also a considerable amount of anecdotal literature.4 9 The most thorough study, conducted by the Government Accounting Office, was completed in January 1998.5 0 In June 19%, the Public Citizen’s Health Research Group released its report on forty-three hospital deals in 1995 involving forty-eight “non-profit” community hospital targets in twenty states.5 1 With few exceptions, the acquiring hospitals were die large “for- profit” chains including Columbia/HCA, OrNda, Tenet Healthcare, and Quorum. Although the report contains no transactional financial data, it does express concern that the non-profit hospital targets may have been undervalued at the time of their acquisition 15 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. or conversion to “for-profit” status. The evidence for under-valuation, however, is anecdotal.” The authors’ recommendations include government oversight both to prevent bargain asset purchases and to monitor the charitable foundations that must be created from the proceeds of the hospital conversion transactions. In September 1996, the Institute for Health Policy issued its report on hospital conversions.3 3 Although die authors state that they could “find no evidence of quality differences” between “non-profit” and “for-profit hospitals,” they expressed concern that “a history of inconsistent regulation and lack of oversight has cost the public the use of billions of dollars in charitable funds.” No individual case studies appear to have been conducted, and the support for die authors’ conclusions that there is widespread under valuation seems to be largely anecdotal. The authors’ conclusion is that government regulation is necessary to prevent bargain purchases and loss to the public of “billions of dollars in charitable funds.” 3 4 In May 1997, die Project Hope Center for Health Affairs issued a detailed report on eight hospitals in seven states that converted from “not-for-profit” to “for-profit” ownership between 1984 and 1996.5 5 The conversions were due to acquisitions by the large “for-profit” chains, principally Tenet Healthcare Corp., Quorum, and Columbia/HCA, and the sales proceeds from the individual transactions ranged from approximately $90 million to $281 million.3 6 Since the focus of the Project Hope study was on the financial motivation for conversions, the effect of conversions upon charity care and hospital staffing levels, and the extent of government oversight of the conversion process, the report is neutral on the subject of the perceived under-valuation problem. 16 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Interestingly, and contrary to some critics of the conversion process, the Project Hope study found the effects of the conversion process to be largely favorable. In January 1998, the General Accounting Office (GAO) released die most comprehensive report on the financial aspects of hospital conversion transactions.5 7 GAO investigators examined fourteen conversion transactions in six states that occurred during the years 1993 through 1996.5 8 In every case, the acquiring corporation was Columbia/HCA Healthcare Corporation (a New York Stock Exchange company), Quorum Health Group, Inc. (a Nasdaq company), or Tenet Healthcare Corporation (a New York Stock Exchange company). Moreover, in every case, the target hospital had obtained either an independent valuation or a “fairness opinion.” 5 9 The GAO reviewed the valuation methodologies that were used to value the acquired “not-for-profit" hospital properties and concluded that standard industry methodologies had been used.6 0 Unfortunately, the government investigators were unable to make independent determinations o f hospital value.6 1 According to the GAO, the net proceeds reported from the fourteen conversion transactions amounted to about $930 million.6 2 The transaction average was about $66 million, and the actual sales proceeds ranged from about $16 million to $212 million.6 3 Of the fourteen conversions reviewed by the GAO, twelve (12) resulted in the creation o f new charitable foundations.6 4 Of the twelve charitable foundations reviewed by GAO investigators, only eight had engaged in any grant-making activities during the period under review. According to the GAO, the grants that were made supported a “variety of projects, many o f them health-related.” 6 5 17 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The GAO reviewed one California conversion transaction: the 1996 purchase of assets of Good Samaritan Health System (located in Santa Clara County, California) by Notami Hospitals of California, Inc., an affiliate of Columbia/HCA Healthcare Corporation, for approximately $176.5 million cash.*6 A valuation report prepared by Shattuck Hammond Partners, a health care consulting and investment-banking firm, 6 7 estimated the total value o f the acquired assets to be in the $143 million - $166 million range.6 8 Because of this asset purchase, the Good Samaritan Charitable Trust was endowed with $72 million.6 9 At the time of the GAO’s review of this conversion transaction, die Good Samaritan Charitable Trust had yet to award any grants.7 0 In 1999, the West Coast Regional Office (San Francisco) of Consumers Union, the publisher of Consumer Reports, released its report on eleven hospital conversions in California from 1993 to 1998.7 1 The report contains several valuation anecdotes but it offers no independent analysis. Its principal findings are that hospital conversions tend to produce a decrease in the level of charity patient care and, interestingly, an increase in the amount of bad debts.7 2 The report makes recommendations for improved Attorney General oversight of hospital conversion health care foundations and it believes that California law should be amended to regulate the growing incidence of nonprofit hospital mergers.7 3 1.6 Dissertation Purpose and Objectives Although the GAO concluded that concerns about conversion transactions are still warranted because the transactions involve millions of dollars in charitable assets, it also said that increased state oversight can be expected to address two critical issues: the 1 8 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. community’s need to obtain fair market value for charitable assets and the community’s need to ensure that the proceeds of conversion transactions are being appropriately used for charitable purposes.7 4 In its report, the GAO considered the impact of new state hospital conversion legislation and die recommendations put forth by the National Association of Attorneys General, but it declined to make any specific regulatory recommendations. It is against this backdrop that this dissertation examines six California hospital conversion transactions that occurred between the years 1995 and 1997 for the purpose of considering the following questions: 1. Does the available evidence indicate that the selling hospital received fair market value for its hospital assets? 2. Was the proposed use of the proceeds from the sale of the hospital consistent with the hospital’s historic charitable purpose? 3. What additional regulatory recommendations are prudent and appropriate to protect the public interest in hospital conversions? This dissertation examines the transactions shown in Table 2. 19 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 2: California Hospital Conversions Nonprofit Community Hospitals Year Purchase Price Acquirer Good Samaritan Health System 19 9 5 $165,000,000 Columbia/HCA Centinela Valley Health Services 1996 $96,800,000 OrNda Health Corp. Pacific Hospital of Long B each 1996 $5,500,000 HealthSmart United Western Medical Centers 1996 $177,483,000 OrNda Health Corp. Queen of Angels 1997 $86,400,000 Tenet HeaithSystem Riverside Community H ospital 1997 $70400,000 Columbia/HCA Source: California Attorney General’s public hospital conversion files. O f the six transactions listed in Table 2 and described in the Consumers Union 1999 report, only two occurred after the effective date (January 1, 1997) of California’s new hospital conversion law.7 s Nevertheless, the Attorney General was still obligated to evaluate the merits of pre-1977 hospital conversion transactions under his general statutory and common law duties.7 6 As previously mentioned, the GAO studied the Good Samaritan Health System transaction but it did not attempt to make an independent valuation of the hospital’s assets. In addition to the above consummated transactions, in 1996 Columbia/HCA proposed to purchase the assets of San Diego Hospital Association and its affiliates, which are engaged in business under the name “Sharp Healthcare,” for approximately $200 million in cash and securities (i.e., approximately $200 million in cash and a 50% interest in a limited liability company worth the remainder). However, because of the Attorney General’s inquiries and valuation concerns, the hospital’s board of directors terminated the proposed sale of the hospital’s assets to Columbia/HCA.7 7 20 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1.7 Organization of the Following Chapters Chapter 2 reviews the theory of business enterprise valuation. The technical appendix to Chapter 2 (Appendix B) presents the results of seven hospital valuation case studies (the six transactions that were consummated, plus the terminated Sharp Healthcare transaction), which I obtained from the Attorney General’s public hospital conversion transaction files. Chapter 3 discusses how the charitable proceeds ought to be managed and used to further the public interest In addition, Chapter 3 presents an overview o f the mechanics of the charitable set-aside requirement Chapter 4 presents some recommendations to improve the regulatory process as it applies to hospital conversion transactions. Chapter S summarizes the dissertation and its principal findings. 21 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Chapter 1 1 For a general overview, see Janies R . Schwartz and H Chester Horn, Jr., Health Care Alliances and Conversions: A Handbook for Nonprofit Directors and Trustees (San Francisco: Jossey- Bass Publishers, 1999). 2 For a legal overview of mergers and acquisitions, see Patrick A . Gaughan, Mergers. Acquisitions, and Corporate Restructurings. 2 ed. (New York: John W iley & Sons, 1999). For a financial and economic overview of m ergers and acquisitions, see J. Fred Weston, fC w a n g S . Chung, and Juan A. Shi, Takeovers. Restructuring, and Corporate Governance. 2 "* ed. (Saddle River, N J: Prentice Hall, 1998). 3 A significant number of acquired companies are soon sold. See Steven N . Kaplan and M ichael S. Weisbach, “The Success of Acquisitions: Evidence from Divestitures,” 47(1) Journal o f Finance 107- 138 (March 1992). 4 Not all tax-exempt corporations or organizations are “charitable.” To be “charitable,” a tax- exempt corporation or organization must satisfy die requirements of Internal Revenue Code of 1986, § 501(c)(3). Whether a corporation or organization is “charitable” is a question of all the facts and circumstances and, due to historical precedents, English common law. N o n government community non-profit hospitals are typically (but not always) “charitable” w ithin the meaning of the federal income tax statute. See generally Frances R . Hill and Barbara L Kirschten, Federal and State Taxation o f Exempt Organizations (New York: Warren, G orham & Lam ont, 1994), ch. 3. 5 See Howard L. Oleck and Martha E . Stewart, Nonprofit Corporations. Organizations, and Associations, 6* ed. (Englewood Cliffs, N J: Prentice Hall, 1994), ch. 45. For example, N ew York law contains stringent hospital ownership rules. See 65 New York Jurisprudence 2d, “Hospitals and Related Health Care Facilities” § 50 (1999). Under California law, a nonprofit public benefit corporation may transfer its assets (e.g., by sale or merger) to a “for-profit” business corporation only if the Attorney General consents to the transaction. See Calif. Corp. Code, § § 5910 - 5913, 6010 - 6022 (Deering’ s 2000). Special rules govern hospitals and other “health facilities.” See Calif. Corp. Code, §§ 5914 - 5 9 2 5 (Deering’ s 2000). 6 This is a requirement of California’ s Nonprofit Public Benefit Corporation Law and the incom e tax regulations under Internal Revenue Code of 1986, § 501(cX3). 22 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 7 Under California law, the assets of a “nonprofit public benefit corporation” may not be distributed without appropriate administrative or judicial supervision. See Calif. Corp. C ode, § § 5410,6710 - 6721 (Deering’s 2000). Under federal income tax law, the assets of a tax-exempt “charitable” organization (trust or corporation) must be irrevocably dedicated to charitable purposes. See 26 Code of Federal Regulations § 1J01(c X 3)-1 (bX 4) (2000). 8 See Calif. Corp. Code §§5914 - 5925 (Deering’s 2000). 9 Paul Starr, The Social Transformation o f American Medicine (New York; Basic Books, 19 8 2 ), pp. 428 - 436. 1 0 See M . Gregg Blocbe, “Corporate Takeover of Teaching Hospitals,” 65(3) Southern California Law Review 1035 - 1170 (March, 1992). 1 1 Standard & Poors Industry Survey, “Healthcare: Facilities,” 166(19) Standard & Poor’ s Industry Surveys 1 (May 7, 1998). According to KPM G LLP, the profit margin percentage generated by the American Hospital Association’s “for-profit” m embers from 1986 through 19% ranged between 5 and 6 percent of revenue, and hospital industry profits grew from approximately $8 billion to more than SI7 billion. Source: K PM G Health Ventures, Healthcare Industry Report 1997: Financial Performance Review: Five Year Historical Report (1992 - 1996) (Hilton Head, SC: W D I Capital M arkets, Inc., 1997). 1 2 Source: Standard & Poor’ s Stock Report, Columbia/HCA Healthcare, March 7 , 1 9 9 8 . Columbia’ s rapid growth was not without severe m anagement and regulatory problem s. Recently, HCA-The Healthcare Co. (formerly Columbia/HCA Healthcare Corp.) agreed to pay a record $840 million in criminal fines due to alleged Medicare billing fraud. Lucette l-» gn « A n “HCA Units’ Guilty Pleas Resolve Largest Medicare Criminal Probe,” The Wall Street Journal, B10, Friday, December 15,2000. 1 3 See Bernstein Research, “Major Medical M ergers Creating Powerful Agents of Change,” (N ew York: Sanford C. Bernstein & Co., M ay 1 9 9 7 ). According to Bernstein Research, as of early 1997 Columbia/HCA owned nearly 55% of all ’ Tor-profit” taxable hospitals in the United States, and Columbia’s “key opportunity is to acquire some of the 85% of the hospital beds in the country that are owned by not-for-profit, tax-exempt organizations." Columbia grew due to a series of private sector hospital acquisitions in die early 1990s. 1 4 See J. D . Kleinke, et aL, “A Paradigm Lost: The Case for Columbia/HCA,” / 7(2) Health Affairs 7 -3 9 (March/April 1998). 1 5 Statement from Congressman Fortney Pete Stark (D-CA) before the House of Representatives (January 9, 1997) concerning proposed legislation to regulate hospital conversions. See www.house.oov/staf1c/documents/conversion.htnil (November 19,2000). 1 6 Robert Kuttner, “Columbia/HCA and the Resurgence of the For-Profit Hospital Business,” 335(5) New England Journal o f Medicine 362 - 367 (August 1 , 19%) (part I), 446 (August 8, 19%) (part 2) 23 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 7 Terese Hudson, “The Fear Factor,” 70(11) Hospitals 42 (June S, 19% ). 1 8 There is also the argument, predicated largely on grounds of efficiency and paucity of actual community benefit, that non-profit health care facilities, including hospitals, should never have been granted tax-exempt status in the first place. See David A. H ym an, “ The Conundrum of Charitability: Reassessing Tax Exemption for Hospitals,” 16 American Journal o f Law and Medicine 327 (1990). See also Alice A. Noble, Andrew L. H yam s, and Nancy M . Kane, “Charitable Hospital Accountability: A Review and Analysis of Legal and Policy Initiatives,” 26(2) Journal o f Law. Medicine < £ Ethics 116 - 137 (Summer 1998). 1 9 Judith E. Bell, Harry M . Snyder, and Christine C. Tien, “ The Public Interest in Conversions of Nonprofit Health Charities” (New York: Milbank Memorial Fund, 1 9 9 7 ). 2 0 Project Hope Center for Health Affairs, The Community Impact o f Hospital Mergers and Conversions (Bethesda, M D : Center for Health Affairs, M ay 1997). 2 1 Volunteer Trustees Foundation for Research and Education, W h e n Your Community Hospital Goes Up for Sale (Washington, DC: Volunteer Trustees Foundation for Research and Education, 19%). 2 2 On October 1 7 and 1 8, 19%, the New York University School of Law’ s National Center on Philanthropy and the L aw sponsored a conference on hospital conversion transactions. The published conference materials are entitled “Conversion Transactions: Changing Between Nonprofit and For-Profit Form .” 2 3 See James J. Fishman and Stephen Schwarz, Nonprofit Organizations: Cases and Materials (New York: Foundation Press, 2 n d ed., 2000), p. 135, citing research done by Bradford Gray. 2 4 U.S. Census Bureau, Statistical Abstract o f the United States: 1 9 99 , 119* ed. (Washington, D.C., 1999), Table No. 204. Non-profit “public benefit” community hospitals are charitable institutions. Private “for profit” hospitals include privately owned “for profit” hospitals as well as publicly owned “for profit” hospitals. The difference lies in whether the hospital company’ s stock is closely held and thus owned by a select group of investors, or whether the company’s stock is traded on an established stock exchange (e.g., American, N ew York, or Nasdaq). 2 5 See David A. Hyman, “Hospital Conversions: Fact, Fantasy, and Regulatory Follies,” 23(4) Journal o f Corporation Law 7 4 1 - 778 (Summer 1998). 2 6 See David Shactman and Andrea Fishman, “State Regulations of Health Industry Conversions from Not-for-Profit to For-Profit Status,” Institute for Health Policy, Heller Graduate School, Brandeis University (December 30,1996). 2 7 The FHP conversion is discussed in Theresa M cMahon, “Fair V alue: The Conversion of Nonprofit H M O s, 30(2) University o f San Francisco Law Review 355 - 392 (Winter 19%). 2 8 See Alister McAlister, “Interim Hearing: Review of Departments of Corporations, Insurance and Justice Responsibilities’ ’ in Conversion o f Public Benefit Corporation from Nonprofit to 24 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. For-Profit Status: Case Study - F P H , Inc. and Foundation Health Plan Conversions and Involvement o f Additional Health Plans,'’ California Legislature, Assembly Committee on Finance and Insurance (Hearing Transcript, December 4,1986). 2 9 The charitable trust received approximately $7.2 million cash and approximately $30.8 in promissory notes. One note (approximately $2.4 million) was due in 2 years and bore interest at the rate of 1 0 % per yean the other note (approximately $28.4 million) w as due in 1 0 years and it too bore interest at die rate of 1 0 % per year. 3 0 V a n de Kamp v . Gumbiner, 221 Cal.App.3d 1260 (CaL C t App. 1990). 3 1 State o f Florida ex reL Butterworth v . Anclote Manor Hospital, 566 So .2d 296 (Fla. Dist Ct App. 1990). Additional facts appear in a memorandum decision of the U .S . Tax Court, Anclote Psychiatric Center v. Commissioner, T.C. Memo 1995-595. 3 2 Mary v. Lupin Foundation, 609 So. 2d 1 8 4 (La. 1992). 3 3 Calif. Corp. Code, § 5913 (Deering’ s 2000). If however, the sales or other dispositive transaction is “in the usual and regular course of” die nonprofit public benefit corporation’s activities, no notice is required. In the case of a nonprofit public benefit hospital, a sale or other transfer of the hospital’ s operating assets to a “ for-profit” corporation would be well within the statute’s regulatory purpose. I did not research the law in effect before 1 9 8 0 , the operative date of section 5913. 3 4 Calif. Corp. Code, § 5142 (Deering’s 2000). 3 5 Ibid. 3 6 But see V a n de Kamp v. Gumbiner, 2 2 1 CaLAppJd 1260 (Cal. Ct App. 1 9 9 0 ). 3 7 See Assembly Committee on Health, “Hearings on AB 3101 (Isenberg),” chaired by Brett Granhmd, held April 23,19%, Sacramento, CA. Available online at < w o w .ie o in f o .c a / o o v . 3 8 Ibid., p. 4. 3 9 The enabling statute does not define “material amount” but under regulations adopted by the Attorney General the term “material” refers to more than a 20% interest in the assets of the nonprofit hospital or other health facility being sold or otherwise transferred. 1 1 California Code of Regulations § 999.5(a)(1) (2000). 4 0 Calif. Corp. Code, §§5914-5915 (Deering’s 2000). 4 1 Calif. Corp. Code, § 5916 (Deering’ s 2000). 4 2 Calif. Corp. Code, § 5917 (Deering’s 2000). 25 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4 3 See Stats. 1996, ch. 1105, in either Statutes o f California and Digests o f Measures (1996) or Statutes and Amendments to the Codes— California (1996). 4 4 Calif. Corp. Code, § 5918 (Deering’s 2000). 4 5 1 1 California Code of Regulations § 999.5(e) (2000). 4 6 The seven components of the protocol are: (1) in fo rm a tio n gathering, (2) review of applicable fiduciary standards to prevent self-dealing and ensure the existence of an arm’ s-length transaction, (3) review of transactional details, (4) analysis of fair market value, (5) analysis of potential inurement, (6) public interest review, and (7) use of proceeds for charitable purposes. 4 7 An excellent source of materials is available from the Kellogg Healthcare Conversion Inform ation Project, the Massachusetts Office of die Attorney General, Public Charities Division, Boston, M A . See www.healtticafeconvef5ion.orp. 48 See K evin F. Donohue, “Crossroads in Hospital Conversions— A Survey of Nonprofit Hospital Conversion Legislation,’ ’ 8 Annals o f Health Law 39 - 96 (1999). 4 9 In general, see Special Issue, “Hospital & Health Plan Conversions," 16(2) Health Affairs (M arch/April 1997). See also James D. Standish, “Hospital Conversion Revenue: A Critical Analysis of Present Law and Future Proposals to Reform the Manner in Which Revenue Generated from Hospital Conversions is Employed," 15(1) Journal o f Contemporary Health Law and Policy 1 3 1 - 182 (Fall 1998), and Phillip P. Bisesi, “Conversion of Nonprofit Health Care Entities to For-Profit Status," 26(4) Capital University Law Review 805 - 846 (1997). A considerable amount of information about hospital conversions is available from D uke University’ s Center for Health Policy Law and Management See www.hpoBcv.dufce.edu. 50 See U nited States General Accounting Office, Report to Congressional Requesters, “Not-For- Profit Hospitals: Conversion Issues Prompt Increased State Oversight" GAO/HEHS-98-24 (Decem ber 1997). 5 1 M ary Gabay and Sidney M. Wolfe, “W ho Controls the Local Hospital? The Current Hospital M erger and Acquisition Craze and the Disturbing Trend of Not-For-Profit Hospital Conversions to For-Profit Status" (Public Citizen’s Health Research Group, June 1996). The report lists 5 8 hospitals, 1 0 of which were government owned at the time of acquisition. 5 2 The report cites three health maintenance organization conversion transactions and one non profit hospital conversion transaction. The reported source of dm transactions is Anne Lowrey Bailey, “Charities Win, Lose in Health Shuffle," The Chronicle o f Philanthropy, June 1 4, 1994, pp. 1,11-13. 5 3 David Shactman and Stuart H. Altman, “ The Conversion of Hospitals from Not-for-Profit to For-Profit Status," Institute for Health Policy, The Heller School, Brandeis University (Septem ber 26,19%). 26 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5 4 See also David Shactm an and Andrea Fishman, “ State Regulations of Health Industry Conversions from Not-For-Profit to For-Profit Status,” Institute for Health Policy, The Heller School, Brandeis University (December 30,1996). 5 5 Project Hope Center for H ealth Affairs, “The Com m unity Impact of Hospital Mergers and Conversions: Summary of Findings,” May 1997. 5 6 In three transactions, no successor charitable organization was established because of either insufficient funds or the existence of a reversionary interest in another non-profit organization. 5 7 See United States General Accounting Office, Report to Congressional Requesters, “Not-For- Profit Hospitals: Conversion Issues Prompt Increased State Oversight,” GAO/HEHS-98-24 (December 1997). Hereafter cited as “GAO Report.” California Democratic Representative Fortney Pete Stark, who publicly stated that hospital conversions were the “giveaway of the nineties” and that Cohtmbia/HCA was the “PAC-MAN” of the hospital industry, w as a principal requester of the GAO report For a statement of Rep. Stark's concerns and his proposed bill to protect the public interest in hospital conversions, see his statement entitled, “ The Pursuit of Profit Non-Profit Hospitals Becom e the Big Public Giveaway of the Nineties,” 143(2) Congressional Record E82 - E83 (Thursday, January 9, 1997) or www.house.gov/staric/docuinents/conversion.htinl (November 19,2000). 5 8 GAO Report, Table 1 , p. 4. 5 9 GAO Report, p. 8. 6 0 Ibid. 6 1 The GAO’s investigation w as somewhat limited because, according to the G A O , in most cases neither the acquiring corporation nor the acquired corporation was willing to provide a copy of the acquisition agreement, valuation study, or other pertinent acquisition documents to GAO investigators for tbeir review. See GAO Report, p. 2. 6 2 GAO Report, p. S . 6 3 GAO Report, pp. 1 3 - 1 4 . 6 4 GAO Report pp. 1 8 - 1 9 . Proceeds from the two rem aining conversions were directed to a tax- exempt private university and a municipality. 6 5 GAO Report, p. 20. 6 6 GAO Report Table 6, p. IS . The actual asset purchase agreement dated as of December 1 3, 1 9 9 S between the Good Sam aritan Health System and Notami Hospitals of California, Inc. reflects a purchase price of $ 1 6 5 million cash, The agreement however, provides that the actual cash purchase price is to be adjusted on the closing date to reflect any increase or decrease in the seller’s net working capital. 27 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 6 7 See w www.shaducktaminond.com. Shattuck Hammond Partners is with PricewaterhouseCoopers, one of tbe “Big Five” international public accountancy firms. 6 8 Table 4 in tbe GAO Report (p. 12) shows tbe valuation estimate to be in tbe $140 million - $160 million range. This is consistent with tbe Shattuck Hammond Partners valuation report dated October 26, 1995. The GAO Report’s $143 million - $166 million range includes Shattuck Hammond’s estimate of tbe value of other included assets. M GAO Report, Table 8, p. 1 9 . 7 0 GAO Report, p. 21. 7 1 Julio Mateo, Jr. and Jaime Rossi, “White Knights or Trojan Horses? A Policy and Legal Framework for Evaluating Hospital Consolidations in California'’ (San Francisco: Consumers Union, April 1999). The report is available only in P D F format from www.consumefsunkxi.om/health/white kniohts.htm. 7 2 One would think that because uncompensated patient care and bad debts are intertwined, a “for- profit” hospital would have fewer bad debts than a nonprofit hospital. See, e.g., William Buczko, “Factors Affecting Charity Care and Bad Debt Charges in W ashington Hospitals,” 39(2) Hospital & Health Services Administration 179- 191 (Summer 1994). 7 3 For the current regulatory aspects of nonprofit mergers, see Garry W . Jenkins, “The Powerful Possibilities of Nonprofit Mergers: Supporting Strategic Consolidation Through Law and Public Policy,” 74(4) Southern California Law Review 1089 - 1132 (May 2001). 7 4 GAO Report, p. 31. 7 5 In California, while there has been extensive hospital merger activity and som e significant (in terms of size) health service plan or health m aintenance organization conversions, there have been relatively few hospital conversions. See Carl J. Schramm and Steven C . Renn, “Hospital Mergers, Market Concentration and the Herfindahl-Hirschman Index,” 33(4) Emmy Law Journal 869 - 888 (Fall 1984) (examining California’s extensive hospital merger activity in the late 1970s). In California, H M O conversions are regulated by the Department of Corporations. See www.cofD.ca.Qov. In 19%, when Blue Cross of California, a “non-profit” H M O was acquired by Wellpoint Health Networks, Inc., a “for-profit” Delaware corporation, the sales proceeds were sufficient to endow what is now a $3.7 billion (in assets) non-profit, tax-exempt charitable (private) foundation for the benefit of all California residents. See www.catendow.ofo. For background information on die creation of the charitable foundation, see California Department of Corporations N ew s Releases Nos. 96-05 (March 5, 19%) and 96-09 (May 21, 1996). Available online at www.cofp.ca.oov. For a discussion of California H M O conversion issues, see Theresa M cM ahon, “Fair Value: The Conversion of Nonprofit HMOs, 30 University o f San Francisco Law Review 355 - 392 (Winter 19% ). 28 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. W ith some exceptions, the California Attorney General’s hospital conversion files and D e partment of Corporation’ s HM O conversion files are open to die public under the provisions of the California Public Records Act, Gov. Code § 6250 etseq. (Deering’s 2000). 7 6 See Calif. Corp. Code §§ 5142,5250,5913 (Deering’s 2000). 7 7 See California Attorney General Press Release No. 97-017 (February 21,1997). 29 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 2 The B usiness Enterprise Valuation o f Hospitals 2.1 Introduction An independent determination of a tax-exempt nonprofit hospital’s fair market value or sales price is important because the assets of a tax-exempt nonprofit hospital are impressed with a charitable trust for the public’s benefit The proper valuation of the selling nonprofit hospital’s business assets is necessary to prevent private inurement or unjust individual enrichment, as well as to make certain that the post-conversion charitable entity will receive its proper entitlement As the preceding chapter illustrated, some of the early hospital and HMO conversions, particularly those that occurred during die 1980s, were plagued with valuations that were too low and which produced unwarranted private windfalls at the public’s expense.1 2.2 The Statutory Standard Under California’s statutory hospital conversion provisions, the Attorney General must approve a nonprofit public benefit corporation’s sale or transfer of its assets to a “for- profit” entity to make certain that the terms and conditions of the sale or asset transfer are 30 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. “fair and reasonable*' to die selling nonprofit public benefit corporation.2 Among other factors, the California Attorney General is required to consider whether die non-profit seller will receive an amount equal to tbe “fair market value” of the assets that are being sold to die “for-profit” purchaser. Under tbe applicable hospital conversion statute, the term “fair market value” means3 [t]he most likely price that the assets being sold would bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and in their own best interest, and a reasonable time being allowed for exposure in the open market This definition assumes reasonable (albeit not “perfect”) information, the existence of an open and public market and adequate time for responsible decision-making. Similar definitions may be found in other statutes and regulations, especially the regulations that govern the determination of fair market value for federal tax purposes.4 Ideally, there should be many buyers competing for the opportunity to purchase the hospital or business enterprise so that a single seller will obtain the highest possible price. In economic theory, it does not matter whether purchase bids are made “openly” or publicly so that any bidder can observe the bidding behavior of his rivals, or whether the purchase bids are “sealed” and privately submitted.3 What is important is there be a sufficient number of interested bidders, as even one additional bidder can be advantageous to the seller for revenue maximization purposes.6 Accordingly, it is not surprising that the California Attorney General’s regulations and office practices emphasize the use of aggressive marketing by investment bankers and other specialists to foster competitive bidding and competing offers for the purpose of sales or asset price maximization.7 31 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Unfortunately, the number of bidders is sometimes so low as to render the auction process essentially equivalent to a negotiated sales transaction. With few rivals or bidders there is always the danger of collusion and so, to prevent unjust enrichment or private inurement, the Attorney General must have an appropriate method o f determining die hospital's apparent “fair market value.” Economically and financially speaking, die purchase and sale of a prototypical “non-profit” tax-exempt hospital represents die purchase and sale of a “going (business) concern.” In this context, the term “going concern” simply means that the acquired or purchased hospital will be expected to continue its normal operating activities indefinitely so that its sale should not be regarded as an act of liquidation or abandonment of business activities.' Consequently, the value of the hospital’s real and personal property on a piecemeal basis is unimportant because its assets will not be sold separately. One hospital valuation analyst has stated:9 When it comes to healthcare, separating the value of a facility from the value of the business is difficult and often misleading because health facilitics-particuiarly hospitals— are specialized and of limited use. They acquire value only when operated as businesses. . . . Hospitals are virtually impossible to convert to an alternative use and are, therefore, single-use facilities. (9 - 10) An example of this analyst’s view is the 1989 merger of Queen o f Angels Hospital and Hollywood Presbyterian Hospital, both California nonprofit public benefit tax-exempt corporations. The old Queen of Angels hospital facility on Bellvue Avenue in Los Angeles had been closed for several years. The offer of a Los Angeles real estate developer, who had sought to purchase the closed facility for $10 million cash, representing an amount equal to the value of the underlying land, was declined. The developer would have razed 32 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the structures and built condominiums on the land. In 1995, the closed facility was finally sold to a nonprofit religious corporation for a S3.4 million promissory note. The old hospital buildings are still vacant and they must be razed because they are unsafe to occupy due to earthquake damage. The management of Queen of Angels should have accepted the real estate developer’s offer of $10 million cash. To management’s surprise, land values failed to rise and, in fact, they substantially decreased.1 0 Because hospitals are single-use facilities that have no value apart from their “going concern” business activities, the market value o f hospitals tends to be cash flow driven. Cash revenues (which depend upon patient capacity, patient utilization, and insurance and government program reimbursement policies) and cash expenses are critical in valuing a hospital enterprise." Fortunately, in both modem financial theory and practice this is no different from the valuation of any other business enterprise. Moreover, it does not matter whether the hospital to be valued is a “for-profit" or “non-profit” hospital because the methodological considerations of the cash flow analysis are the same.1 2 2 3 The Theory of Business Enterprise Valuation In the absence of a market containing many buyers and sellers, the question of fair market value is somewhat illusive. Some might even say “fair market value” is illusory. For our purpose, however, the object of the exercise is to determine what a “willing” “for- profit” buyer should agree to pay a “willing” “nonprofit” seller who is not under any compulsion to sell an income-producing asset (i.e., a hospital). The three approaches that are widely used in business valuation practice for valuing privately held business 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. enterprises, including health-care and hospitals enterprises, are the cost approach, die market approach, and the income or discounted cash flow approach.1 3 2.3.1 The Cost Approach The cost approach emphasizes the cost o f replacing or recreating the present state of a business enterprise's physical assets; i.e., the enterprise’s land, buildings, and machinery and equipment The critical question is “What would it cost Columbia/HCA or another ‘for-profit’ hospital chain to construct an acute care facility from scratch?” Land would have to be bought, special purpose buildings would have to be erected, and highly specialized equipment and supplies would have to be purchased. All of this might consume several years in planning and construction. Business appraisers typically use current replacement cost less depreciation or obsolescence, to estimate the fair market value of real and personal property. Unfortunately, hospital real property is limited use property: only another hospital would be interested in purchasing a hospital’s physical plant (i.e., land and buildings) because hospital buildings cannot be adapted to an alternative use or purpose without the buyer’s willingness to incur considerable, and sometimes even extraordinary, rehabilitation expenditures. Hospital personal property (e.g., operating room and laboratory equipment) is even more specialized so that no general second-hand market for used hospital equipment exists. Since the value of a hospital as a going concern is a function of the quality and size of the hospital’s physical plant and equipment, the skills of its medical and nursing staff, the business acumen of its administrators, and community demographic and 34 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. economic factors, the cost of replacing die hospital’s real and personal property on a stand alone basis is not considered to be indicative of business enterprise value. 2.3.2 The Market Approach The market approach relies on statistical data derived from publicly or privately reported transactions to determine the value of a particular business enterprise. In practice, both the comparable transactions approach and the comparable companies approach are used. In both cases, statistical ratios based upon known transactional data are used to predict or forecast the value of the unknown business enterprise. Standard data sources for many commercial enterprises include Shannon Pratt’s “Business Valuation Update” and, for hospitals, Irving Levin Associates, Inc.’s “Hospital Acquisition Report” 1 4 These sources, however, may contain reporting, analytical, and arithmetic errors. 2.3.2.1 T he C omparable T ransacti ons approach In the comparable transactions approach, the kernel of the idea is to discern the value of an unknown asset or proposed transaction (e.g., the sale of a hospital) by comparing die financial characteristics of the unknown asset (e.g., in the case of a hospital, its net patient revenue, net income or cash flow, number of beds, or other metrics) with those of an asset whose value has been previously ascertained or established through public market transactions.ts This methodology is suitable for a seller who is seeking confirmation (perhaps a “fairness opinion” from an outside professional) that the proposed sales price is “fair and reasonable” in relation to similar transactional values. When this 35 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. method is used, the population variance must be reasonably small and the qualitative characteristics of the asset (hospital) to be valued must be similar to the characteristics of those included in the commercial database. Furthermore, in the absence of appropriate and relatively stable (over time) transactional relationships, this method may be seriously flawed. To illustrate the application of this method, consider the 1997 sale of Riverside Community Hospital, a non-profit, tax-exempt 369-bed acute care general hospital, to Columbia /HCA for approximately $70.5 million (part o f the consideration was paid in cash and part of consideration was an equity interest in a newly formed LLQ. Table 3 summarizes some pertinent non-profit hospital acquisition information from Irving Levin Associates for the years 1994 through 1997, and it shows the transactional means for some key valuation metrics: the ratio of hospital selling price to the number of hospital beds, the ratio of hospital selling price to “earnings before interest, taxes, depreciation, and amortization’ ' (EBITDA), and the ratio of hospital selling price to patient revenue:1 6 36 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3: Nonprofit Hospital Acquisition Statistics 1997 1996 1995 1 9 9 4 Price/Bed Average $238,570 $253308 $277,219 $255,656 Price/Bed Median $201,117 $183,146 $258,811 $215347 Deal count 44 43 36 2 1 Price/EBITDA 738 6.16 6.03 5.74 Average Price/EBITDA 6.44 5.49 633 630 Median Deal count 1 9 27 20 1 7 Price/Revenue 0.92 0.83 0.92 0.89 Average Price/Revenue M edian 0.69 0.70 0.87 0.85 Deal count 42 4 1 36 2 1 Source: Irving Levin Associates, Inc., The Hospital Acquisition Report, 4* ed. (1998). The first and easiest metric to understand is the price per bed. Using the 1997 mean bed price of $238,570, Riverside's sales price should have been approximately $88 million (i.e., $238,570/bed x 369 beds). Using the 1997 median bed price of $201,117, it should have been approximately $74.2 million. (Averages for the three preceding years (i.e., 1996, 199S, and 1994) could be used as well with different valuation results.) Although Riverside Community Hospital was licensed for 369 beds, the number of beds available for actual patient use is unknown. There is often a disparity between the number of licensed beds and die number of beds actually available for patient use. For example, if only 350 beds were available for inpatient use, the median bed price of $201,117 would be consistent with a sales price of $70.5 million. A second, and perhaps more difficult metric to use, is the ratio of the hospital’s purchase price to EBITDA. This metric is commonly used because EBITDA is considered 37 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. to be a useful but imprecise measure of cash flow ,1 7 and businesses are often sold on the basis of cash flow multiples.1 * However, variations in hospital accounting practices, differences in income statement expense account classifications, and die extent to which the analyst believes that cash required for working capital requirements should be held in reserve and thus excluded from the EBITDA calculation, can result in inconsistent EBITDA multiples.1 9 Riverside’s accountants (Ernst & Young LLP) estimated its EBITDA to be approximately $13.68 million. Consequently, using the 1997 mean price-EBITDA ratio of 7.38, the hospital’s sales price should have been approximately $100.9 million (i.e., 7.38 x $13.68 million). Using the 1997 median price-EBITDA ratio of 6.44, the price should have been approximately $88.1 million. The actual price of $70.5 million is consistent with an EBITDA multiple of approximately S.15. Although one might be tempted to conclude that 5.IS is somewhat low, as mentioned previously the method of computing a hospital’s EBITDA is more art than science. The recent GAO report on hospital conversions states that the EBITDA range for the transactions reviewed by the GAO was from five to ten, but that in recent years “investment bankers have commonly applied a multiple of six to value independent not-for-profit hospitals.” 2 0 The third common metric is the ratio of sales price to patient revenue (either net or gross patient revenue, but sometimes this is not entirely clear). For 199S, Riverside Community Hospital’s net patient revenue was approximately $93.2 million so that the relevant ratio ($70.5 million * $93.2 million) is 0.76. According to Table 3, the mean ratio for 1997 non-profit hospital sales transactions was 0.92, and the median ratio was 0.69. Although Riverside Community Hospital’s ratio is greater than the median ratio, as with 38 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. EBITDA there is a need to question die accounting definition of “patient revenue” and consider the aspects of consistency and financial statement comparability. Table 4 applies 1997 transactional information from Irving Levin Associates to the 199S financial data for Riverside Community Hospital, which is the latest available data in die Attorney General’s public file: Table 4: Application of Metrics to Riverside Community Hospital Comparable Transactions 1997 D eals Riverside Community Hospital 1995 Data Implied Value of Riverside Community Hospital Price/Bed Average (mean) $238,570 369 beds $88,032330 Price/Bed Average (median) $201,117 369 beds $74312,173 Price/EBITDA Average (mean) 738 $13,680,000 $100,958,400 Price/EBITDA Average (median) 6.44 $13,680,000 $88,099300 Price/Revenue Average (mean) 0.92 $93300,000 $85,744,000 Price/Revenue Average (median) 0.69 $93300,000 $64308,000 Source: Table 3 and author’ s calculations. Although any one o f the three metrics may be used (or their averages may be used), a significant proportion of recent hospital sales have been priced to yield total enterprise value-to-EBITDA ratios in the range of five to seven,2 1 and this range is consistent with the GAO’s finding of six. The EBITDA metric suggests a value range for Riverside Community Hospital of between $68.4 and $95.7 million, and the actual sales price ($70.5 million) is within that range. Most “for-profit” hospital purchasers use EBITDA because it represents an industry rule of thumb that has been widely disseminated 39 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and referenced in the health care industry. A problem with die EBITDA metric is that one may not know whether or not die hospitals in a specific EBITDA database have similar operating and financial characteristics.2 2 Valuation by using multiples is a second-best method but it is frequently used in the merger and acquisition advisory business as a “sanity check.” 2 3 The “trick” is to select truly comparable acquisitive transactions and choose the right multiples. As a rule, in deriving the relevant multiples (i.e., in hospital purchase transactions, die ratios of sales price to number o f beds, sales price to EBITDA, and sales price to net patient revenue) “abnormal” firms or outliers must be excluded and hospital size must be taken into account For example, in valuing a small rural hospital it makes little sense to use ratios derived from financial data involving die actual sales of large metropolitan hospitals because there are differences in economies of scale. Most rural hospitals have fewer than 100 beds; most metropolitan hospitals have at least 100 beds, and some have more than 300 beds.2 4 The transactional data compiled by Irving Levin Associates, Inc. does not take into account hospital size. Moreover, hospitals can vary in terms of patient composition and demographics, the use of state-of-the-art healthcare technology, the mix of medical services, and other factors. Another problem is that data derived from truly comparable business enterprises should be relatively stable over time, include a sufficient number of data points, and be based upon comparable accounting definitions and principles. For example, during the years 1994 - 1997, the means of the sales price-to-EBITDA ratios (i.e., the EBITDA multipliers) for various hospital target companies and their acquirers exhibited a 40 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. considerable range. Table 5 presents the results as compiled by Irving Levin & Associates, Inc.:2 5 Table 5: Historic EBITDA Multipliers 1997 19% 1 9 9 5 1994 Non-profit hospital targets 738 6.16 6.03 5.74 Deal count 1 9 27 20 1 7 Publicly owned “for-profit” targets 5.11 5.01 5.47 335 Deal count 4 2 4 4 Privately owned “for-profit" targets n/a 3.05 3.47 5.15 Deal count n/a 1 1 3 Summary for all hospital targets 6.99 5.98 5.84 537 Deal count 23 30 25 24 Source: Irving Levin Associates, Inc., The Hospital Acquisition Report, 4* ed. (1998). It is curious that “for-profit” acquiring companies were apparently willing to pay more for non-profit hospital target companies than for “for profit” hospital targets. The relative paucity of “for-profit” deals, however, should be a cause for some restraint Moreover, it is unclear whether or not EBITDA is always calculated in the same manner from company- to-company or transaction-to-transaction. The same definitional problem may affect the derivation of other key ratios or metrics (e.g., sales price per hospital bed and the ratio of sales price-to-patient revenue) as well. Finally, there is the issue of applying ratios derived from older transactional data (I.e., data attributable to prior time periods) to current acquisition transactions. For example, ratio data gleaned from 1994 hospital transactions should not necessarily be applied to 1997 hospital transactions. Table 5 shows a considerable fluctuation in 41 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. EBITDA multiples over time. In many cases, the source o f comparable transactional data is unknown and so the ratios should be used with caution. 2.3.2.2 the C omparable Companies approach As with the comparable transactions approach, the comparable companies approach is useful whenever one wishes to confirm that the sales price is “fair” in relation to the values placed on listed companies by public markets (i.e., stock exchanges). Instead of looking at asset acquisition or purchase transactions, one looks at the key characteristics of comparable publicly traded companies. The object o f the exercise is to value a non-profit enterprise using comparable publicly traded companies as the touchstone or gold standard. For example, two publicly held New York Stock Exchange listed companies dominate the hospital business in the United States: Columbia/HCA Healthcare (symbol COL) and Tenet Healthcare (symbol THC). The stock of a third public company, Quorum Health Group, is listed on Nasdaq (symbol QHGI). Key financial and accounting ratios for these three companies can be determined and averaged; e.g., the ratio of market value of equity to book value of equity (or total assets), the ratio of market value of equity to net income (or EBITDA), and the ratio of market value of equity to gross revenue (or net patient revenue). These ratios can be used to estimate the theoretical market value of a non-profit hospital enterprise. Table 6 shows key company statistics for 1997 for Columbia/HCA Healthcare, Tenet Healthcare Corporation, and Quorum Health Group, Inc.:2 6 42 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 6: Selected Corporate Statistics Columbia Tenet Quorum Average Market-to-book value ratio 3.87 4.49 4.46 4.27 Market-to-EBITDA ratio 10.69 9.83 8.96 9.83 Market-to-patient revenue ratio 1.49 1.66 1.63 1.59 Source: Standard & Poor's. The application of the average of these company ratios to Riverside Community Hospital’s 1995 financial data gives rise to the following implicit valuation (Table 7): Table 7: Implicit Valuation of Riverside Community Hospital Book Value Approach EBIDTA Approach Patient Revenue Approach Riverside’ s data for 1995 $45,477,241 $13,680,248 $68,884,593 Average multipliers (Table 6) 421 9.83 1.5 9 Implicit values (rounded) $194,000,000 $134,000,000 $109,000,000 Source: Author’ s calculations. The valuation discrepancy is substantial because none of the stock exchange listed companies is comparable in size to Riverside Community Hospital. Moreover, different data periods will produce vastly different results. For example, the average market value of equity-to-EBIDTA ratio for the three public companies mentioned above for 1997 is 9.83, but for 1996, it is only 5.61.2 7 An average ratio of 5.61 implies a value for Riverside Community Hospital o f $76.7 million, which is within 10 percent o f the actual sales price of $70.5 million. 43 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The criticisms leveled against the comparable transactions approach apply with equal force to the comparable companies approach. Unless all the companies share similar qualitative characteristics (which is highly unlikely because non-profit hospitals enjoy different revenue sources and special tax exemptions), die comparable companies approach will produce spurious rather than useful results. Abnormal firms or outliers should be excluded, and the hospital that is to be valued should be the same size (in terms of the number of licensed or available beds) as the publicly traded hospitals, the aggregate statistics of which are being used for the purpose of the valuation exercise. 2.3.3 The Income (Discounted Cash Flow) Approach The income or discounted cash flow (DCF) approach to valuation follows modem economic and financial theory because it assumes that the value o f the business enterprise is equal to the present value of the enterprise’s stream of future net cash flows. Virtually every contemporary business or asset-pricing model incorporates present value or time value of money techniques, and this is true whether the asset being valued is a “financial asset” (e.g., stocks, bonds, and derivatives) or a “real asset” (e.g., real property, personal property, or a going business concern).2 * In other words, the present value of estimated future cash flows is implicit in all market prices, whether or not this fact is recognized or appreciated, and a hospital is no exception.2 9 The decision to purchase a hospital as a “going concern” requires that consideration be given to the required cash outflows and their timing (the investment) and the anticipated cash inflows and their timing (the anticipated or expected economic benefits).3 0 44 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The discounted cash flow method is clearly die superior method because it captures all the relevant elements of a company’s economic value: a company’s expected cash receipts and its expected cash expenditures. From a pragmatic point of view, business owners are interested in how much money they will be required to invest in their respective businesses and how much money they will receive over die course of the business life cycle, including bow much money they will receive when die business is sold or completely liquidated. In other words, in die long-run cash is king and nothing else really matters.3 1 From an economist’s point of view, die discounted cash flow method provides assurance that scarce economic resources will be used in a manner that is most efficient3 2 Although it is easy to state the DCF model in mathematical form, it is not always easy to apply the model to business enterprise acquisitions or purchases. There are a number of practical problems that must be surmounted. 2.3.3.1 O perational Definition of C ash Flows The DCF model requires that a purchaser pay no more than the discounted value of the enterprise’s expected future cash flows from operations, or so-called free cash flows. Thus, it is important to realize that what is to be discounted is not the business enterprise’s Financial accounting income, as determined by the application of generally accepted accounting principles, but the business enterprise’s free cash flows (i.e., die cash that is available for distribution to the entity’s bondholders as principal and interest, plus the cash Y ? Cashflow, t r (1 + /)' 45 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. that is available for distribution to the entity’s stockholders as operating or liquidating dividends).3 3 Although EBITDA (“earnings before interest, taxes, depreciation, and amortization”) is often used as a proxy for an enterprise’s cash flows from operations or free cash flows, it is not the same. Unfortunately, until relatively recently cash flow analysis (as opposed to cash flow forecasting) was given scant attention by both “for-profit” and “non-profit” enterprises. In fact, it was not until the Financial Accounting Standards Board (FASB) promulgation of Statement No. 95, in November 1987, that “for-profit” business enterprises were required to include a statement o f cash flows in their issued financial statements for the benefit of creditors and investors. Even then, the FASB’s thinking was that non-profit enterprises had no similar cash flow reporting concerns.3 4 But in June 1993, the FASB promulgated Statement No. 117, which, among other things, now requires non-profit organizations to report cash flows as if they were “for profit” business enterprises.3 5 According to FASB Statements Nos. 95 and 117, an enterprise, whether for profit or non profit, can derive cash flows from investing activities (e.g., the purchase or sale of plant and equipment), financing activities (e.g., proceeds from issuing debt instruments and principal payments to creditors), and operating activities (e.g., cash receipts and disbursements attributable to the enterprise or organization’s principal operating activities). In the case of a hospital, net cash flows from operating activities would take into account cash receipts from patients and third-party payors and cash disbursements made for salaries and wages paid to medical and administrative personnel, plant and equipment maintenance payments, supplies, and other normal operating expenses.3 6 For hospital valuation purposes, a non-profit or a for-profit hospital’s cash flows from operating activities, 46 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. determined in accordance with FASB Statements Nos. 95 and 117, should be the “gold standard” for DCF analysis purposes. There are, however, potential ambiguities First, it is common for interest paid to be treated as an operating activity expense instead of a financing activity expense even though die decision to pay interest is a direct consequence of how the enterprise or organization is to be financed. The effects of financing activities should be completely separated from operating activities.3 7 The FASB considered this issue but chose to allow die prevalent practice of treating interest as an operating expense to continue. Second, the FASB sanctioned two methods for reporting net cash flows from operating activities, the “direct method” and the “indirect method.” The direct method, which is more difficult to apply in practice, shows the principal components of an entity’s cash receipts and disbursements from operations, while the indirect method, which is easier to apply in practice, attempts to arrive at an approximation. Nevertheless, cash flows from operating activities, as determined by the organization’s independent accountant in accordance with the FASB’s applicable standards, is what should be discounted because it is less susceptible to manipulation than other, competing definitions. 2.3.3.2 U se o f Historical C ash Flow s versus F uture C ash Flows Although historical cash flows may help to predict the future, a prospective purchaser is interested in determining the present value of the hospital’s expected juture cash flows for an indefinite period of time, say n periods. In other words, the purchase of a business enterprise is tantamount to the purchase of a contingent annuity. What is required is a forecast or projection of the organization’s future cash flows from operating 47 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. activities.3 8 Although it is patently clear from the fundamental accounting relationships that operating cash flows (CF) for die current period depend upon die results of prior periods; i.e., CF,*, =J{CF„ CF,.,. CFh 2 ,...\ precise model specification is often difficult Relevant model factors or variables would include patient revenues, cash receipts from third-party payors, grants from charitable foundations and government agencies, charitable contributions from the general public, payments to health care and other personnel for salaries and wages, maintenance and operating expenses, and so forth. Because of die difficulty of model specification, electronic spreadsheet cash flow models tend to be simple time series rather than complex explanatory models.3 9 The problem with spreadsheet models (Lotus, Excel, or similar software packages) is that historical patterns tend to be erroneously extrapolated, especially if the model is revenue-based (i.e., next year’s revenue is a linear product of the current year’s revenue), and they tend to be vexed by unreasonable assumptions (sometimes not disclosed to the reader). It is desirable to be able to evaluate the accuracy of forecasts in order to assess forecast performance and identify the optimal forecasting method.4 0 In general, cash flow prediction models, including univariate and multivariate time-series models, have not performed particularly well: lagged multivariate time-series models tend to have an adjusted R2 of less than 0.4,4 1 This may explain why business enterprise valuation is an art rather than a science. Nevertheless, even though it is difficult to predict future cash flows, the evidence tends to show that there is a strong relationship between reported business purchase prices and the discounted value of die corresponding cash flow forecasts.4 2 So even though cash flow forecasts are difficult to make and inaccurate, business purchasers 48 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. do use them for decision-maldng purposes and, as a result, die assessment of a hospital’s cash generating ability is critical.4 3 In the absence of future cash flow forecasts or projections, an organization’s historical cash flows from operating activities could be used to suggest an acquisition price. Using historical operating cash flow data for, say, die past five years, a least-squares method time-series can produce a simple but sometimes useful mechanical extrapolation, albeit one with no underlying rhyme or reason.4 4 It is even possible to combine historical operating cash flow data with forecasted or projected cash flow data to produce a better forecast4 5 2.3.3.3 Predicting T ermi nal or R esidual V alue Because the operations of a business enterprise are expected to continue for an indefinite period of time, the DCF method requires a forecast or projection of the enterprise’s future operating cash flows for an indefinite period of time {i.e., n -* < v ) . The problem is that no matter what method is used, it is frequently futile to attempt to project or forecast an enterprise’s expected future cash flows beyond more than five years. In practice, the net operating cash flows of an enterprise are typically valued in a two-part exercise: the first part of the exercise entails using a forecast method (i.e., a spreadsheet model) to determine the present value of the enterprise’s net operating cash flows for, say, five years; the second part of the exercise entails using a terminal value method (e.g., the “constant growth” annuity method) to determine die present value of the enterprise’s net operating cash flows for all subsequent years. These two segments are then added or combined to yield total business enterprise value {BEV). 49 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. For example, if management can forecast expected cash flows for a period of, say, five years, the calculation is: It is easy to determine the present value of the part that is attributable to management’s cash flow estimates (years 1 through S), but considerably more difficult to determine the remainder. To determine the present value of the remainder (i.e., the part that is attributable to the years 6, 7, 8, ... o o ), the formula for a “constant growth” perpetuity is enterprise’s “terminal” or “residual” value is calculated based upon the questionable assumption that operating cash flows beyond the forecastable period (usually five years or less) can be treated as a “constant growth” annuity.4 7 This gross simplification is necessary because there is no easy way to value contingent or uncertain future cash flows.4 8 2.3.3.4 D etermining the Applicable D iscount R ate The choice of die applicable discount rate (/) is subject to considerable uncertainty and confusion. It is elementary that the discount rate is not the current market rate of interest, although the interest rate is an important component In the capital budgeting-net present value literature, the appropriate discount rate is the investor’s desired rate of return, which is supposed to represent investor compensation for both interest (the time value of money) and financial risk (cash flow statistical variance).4 9 Accordingly, financial economists would value a specific firm by discounting its free cash flows using the firm’s Cashflow, Cashflow, typically used and then the result is discounted to the present4 6 This means that the 50 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. weighted average cost of capital as die appropriate discount rate: the cost o f debt capital would be determined by the firm’s market interest rate applicable to long-term debt, and the cost of equity capital would be determined by die Capital Asset Pricing Model (CAPM).5 0 In practice, there are a number of variations and corporate management may use a specific target or hurdle rate that is independent of the weighted average cost of capital as the discount rate for evaluating specific investment proposals. As a practical matter, the appropriate discount rate should probably range between 10 percent and 20 percent This is because on the corporate debt side, the nominal interest rate on long-term corporate debt is usually between 8 percent and 10 percent, while on the equity side, although the appropriate risk premium for equity capital requires an empirical determination using the CAPM or other market-pricing model, the cost of equity capital can be close to 20 percent Once determined, the applicable discount rate is assumed to remain constant over the life of the project or business enterprise in order to simplify the present value calculations.3 1 In theory, the rate should vary over time. 2.3.3.5 Illustration of DCF Analysis Columbia/HCA’s 1997 purchase of Riverside Community Hospital, the first conversion transaction to be approved by the Attorney General under California’s new hospital sales law ,5 2 can be used to illustrate applied DCF methodology. The reader may recall that the hospital was sold for $70.5 million (the consideration was part cash and part equity interest in a newly formed “for-profit” LLC). Riverside’s DCF business enterprise value of $59,861,819 (approximately $60 million) was derived using the previously discussed two-step analysis: first, the present 5 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. value of the hospital’s future cash flows for the first 5 years following the purchase was determined to be approximately $22,010,000; second, the present value of die residual cash flows was determined to be $37,831,819. Thus, total BEV using the DCF approach was determined to be the sum, $59,861,819 (approximately $60 million). In the first step of the analysis. Riverside’s management coupled with the public accounting firm o f Ernst & Young LLP estimated Riverside’s future net operating cash flows (i.e., the excess of hospital cash receipts over hospital cash expenses and necessary capital maintenance expenditures) to be as follows: Table 8: Riverside Community Hospital Year 1 2 3 4 5 Totals 5-Year Mean Net C ash Flow s $4,067,000 $5,167,000 $6,429,000 $8,901,000 $8,517,000 $33,081,000 $6,616,200 Mid-Year 16%NPV Factors 0.9285 0.8004 0.6900 0.5948 0.5128 NPV $3,776,115 $4,135,723 $4,436,071 $5,294,633 $4,367,427 $22,009,969 Source: Ernst & Young LLP. Using an interest or discount rate of 16% per annum and assuming the cash flows being discounted are mid-year cash flows, the present value of Riverside’s expected net cash flows for the first five years is approximately $22,010,000.5 3 In the second step of the analysis, it is necessary to consider what will be Riverside’s expected net cash flows for the remainder of its business life (i.e., for the years 6, 7, 8, and beyond). Instead of forecasting or projecting these cash flows using prior 52 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. years’ data, standard valuation practice is to (a) estimate these cash flows using a constant growth perpetuity model and then (b) discount the value of the resultant perpetuity back to the base period. The result is the enterprise’s “terminal value.” For the second step calculation, Riverside’s management believed that after year 5 the hospital’s net operating cash flows would grow at the rate of 4% indefinitely. Therefore, the hospital’s net cash flow for year 6 was determined to be 1.04 times $8,517,000, or $8,857,680. If $ 1 today will grow in value at the rate of 4% forever, and if the applicable discount or interest factor is a constant 16%, then die present value of the right to receive that particular variable annuity is simply the quantity $l/(r - g). where i denotes the applicable interest or discount rate and g denotes the annuity’s growth rate.1 4 Mathematically, Using this formula, the present value o f the hospital’s net cash flows for year 6, 7, 8, and beyond was determined to be an amount equal to $8,857,680 divided by 0.12, or $73,814,000. Since $73,814,000 represents the present -value of a variable annuity to commence 5 years from now, that sum must be discounted back to the present Using the mid-year discounting convention, the appropriate discount factor is 0.5128. Consequently, the present value of the residual net cash flows (i.e., the net cash flows for years 6, 7, 8, and so forth) is $37,851,819 (i.e., $73,814,000 x 0.5128). Mathematically, VL16 ^ A $8,857,680 • (1 ■04),'s 1.16s 0.16)' = (0.5128) $8,857,680 (0.16-0.04) * $37,851,819. 53 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. To summarize, using the discounted cash flow method, the value of Riverside Community Hospital is equal to die present value of the expected net cash flows for the years 1 - 5 plus the present value of the estimated terminal or residual net cash flows for years 6, 7, 8, and beyond, or an amount equal to 559,861,000 ($22,010,000 + $37,851,819). In its valuation report, Ernst & Young rounded this amount to $60 million. The actual purchase price agreed to by Columbia/HCA was $70.5 million, representing the greatest amount determined by using any one of die three valuation methods (die comparable transactions approach, the comparable companies approach, and the DCF approach). The Ernst & Young figure of $60 million is subject to the usual criticisms. First, the quality of die financial forecast or projection is unknown. The Attorney General’s public file contained no spreadsheet and no statement of assumptions. Management’s projections and growth assumptions may or may not have been reasonable. Unfortunately, there is no way to know because Ernst & Young did not investigate or otherwise verify management’s cash flow forecasts. Historical net operating cash flows were not considered. Second, estimated net operating cash flows were not prepared in accordance with FASB Statement Nos. 95 and 117; instead, management used a modified EBITDA approach to determine projected operating cash flows. There is no audit trail to link management’s projections to Ernst & Young’s financial statements, including cash flows from operations. Third, the discount rate of 16%, while not prima facie unreasonable, is in itself a source of major variation in business enterprise value. For example, if the interest or discount rate is 16%, the present value of the right to receive $100 at die end of each year 54 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. forever (a perpetuity of S100) is S62S. But if the interest or discount rate is 14%, the present value of that same right is $714—an increase of $89. The moral is that business enterprise value is very sensitive to slight changes in the applicable discount rate.5 5 Finally, in determining residual or terminal value, management assumed that after year 5 the hospital’s cash flows would grow at the constant rate of 4% per annum indefinitely. Unfortunately, there is no support for this figure. Because of the arithmetic of constant growth annuities, a business enterprise’s residual or terminal value is also extremely sensitive to changes in the annuity growth rate. There is an easier way to arrive at essentially the same $60 million (approximately) answer. For years 1 through 5 (Table 8, supra), the arithmetic mean of Riverside Community Hospital’s estimated future net cash flows is $6,616,200. If $6,616,200 is the best estimate of Riverside’s recurring net cash flows, then using a discount rate of 16% the value of the associated perpetuity is $41,351,250 ($6,616,200 + 0.16). This is substantially different from the Ernst & Young value of approximately $60 million and for good reason: contrary to management and Ernst & Young’s valuation assumptions, the perpetuity model does not reflect any element of growth. By definition, it is a static valuation model because the amount that is to be discounted remains constant However, Riverside’s management determined that after year 5 the hospital’s annual net cash flows would grow at the rate of 4% per annum forever. As previously stated, a discount rate of 16% coupled with an annuity growth rate of 4% is equivalent to capitalizing the stream of anticipated future cash flows at 12% (i.e., 16% - 4%). Looking at Table 8, if year 1 ’s cash flow of $4,067,000 is capitalized, the value of the hospital is $33,891,667 ($4,067,000 + 0.12). If year 5’s cash flow of $8,517,000 is capitalized, the 55 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. value of the hospital is $70,975,000 ($8,517,000 + 0.12). If the arithmetic mean of the first 5 years is capitalized, the value of die hospital is $55,135,000 ($6,616,200 - s - 0.12). This figure ($55.1 million) is not very far from Ernst & Young’s figure of $59.8 million.5 6 In Riverside’s case, management’s forecast accounted for $22 million of BEV (37%) and the residual or terminal value calculation accounted for almost $38 million of BEV (63%), for a total of $60 million (approximately). Most valuation academics and practitioners pay considerable attention to the derivation of management’s cash flow forecasts or projections for a period of, say, five years, but devote relatively litde attention to the residual or terminal value calculation and its underlying assumptions.5 7 The determination of residual value is the weakest link in the entire valuation exercise. 2.4 California Valuation Case Studies The Attorney General’s hospital conversion files are “public records” open to inspection under the provisions of the California Public Records A ct Under the Act, it was possible for me to review the files of several conversion transactions. Some of the conversion transactions were under California’s new hospital conversion law, others were prior to the new law but they still entailed Attorney General oversight and valuation decisions. The technical appendix to this chapter (Appendix B) presents the case studies for the hospitals that I reviewed as well as an introduction to the pertinent valuation mathematics. 56 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.5 Conclusions In economic and financial theory, die value of a business enterprise is equal to the present value of the enterprise’s anticipated or expected future operating cash flows. A rational investor is interested in die future because of the belief that, eventually, economies of scale, additional capital investments, and better management techniques will give rise to superior operating results and thus larger free cash flows for the benefit of the enterprise’s investor-owners. Unfortunately, the reality of the marketplace is that many acquisitions do not exceed a rational investor’s expectations. Overpayment in acquisitions is not uncommon because of faulty due diligence, managerial hubris, post-acquisition managerial incompetence, imperfect information, and other, related factors.5 8 The first principal difficulty in business enterprise valuation, and the kernel of the valuation process, is determining future cash flows. John Canning discussed the problem of forecasting cash flows almost seventy years ago in his classic, The Economics o f Accountancy.5 9 According to Canning, the “future rents” or cash flows of a business enterprise “constitute an infinite series that can, term by term, take on a very great range in value and may be either positive or negative in sign.” He was correct to observe that it is “rarely, if ever, possible statistically to project either the series of receipts or the series of disbursements far into the future.” In addition, with great lucidity he stated, “A theory of value may be conceptual only—most theories of value are. But theories of valuation are statistical.” He also pointed out that many times it is not possible to justify a choice of valuation method on “any better grounds than arbitrary personal preference.” He also recognized, correctly I believe, that quite often it is impossible to prove one method of 57 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. valuation to be better than another. In other words, there are no general criteria for die purpose of establishing die superiority of one method over another. Electronic spreadsheets have not diminished the quality of Canning’s insight into the valuation conundrum. In fact, their widespread use has made his insight more pertinent now than before. If cash flow forecasts or projections are to be used for valuation purposes, as indeed they must, then the official guidelines promulgated by the American Institute of Certified Public Accountants (AICPA) should be followed.6 0 The AICPA’s guidelines distinguish a “financial forecast” from a “financial projection.” They are not the same. A financial forecast is a mechanical extrapolation from existing (or historical) financial conditions; a financial projection incorporates one or more hypothetical assumptions (e.g., what would happen to cash flow from operating activities if the patient load were increased by 5% or if maintenance expenses could be decreased by 10%?) In the hospital transactions I reviewed, management’s free cash flow forecasts or projections were not made in accordance with the AICPA’s guidelines. For the most part, the relevant income and expense statements were not shown and the financial and operating assumptions were not disclosed to the reader. It should be possible to link cash flow forecasts or projections to the hospital’s historic operating or financial data, but this was not done. In none of the valuation cases I reviewed was it possible to find an audit trail for the purpose of tracing the free cash flow forecasts or projections to historic financial statement information. In fact, in most of die valuation cases pertinent financial statement information was missing from the public file. In some o f the valuation reports what was discounted was ambiguous. Some valuation analysts discounted “earnings” (or some variation thereof such as EBITDA) and 58 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. some discounted “free cash flows.” Although cadi flows are what are to be discounted, a uniform definition of “free cash flow” needs to be implemented. Current practice allows too much manipulation by way of adjustments for anticipated working capital needs and proposed capital expenditures. To minimize the cash flow illusion so that die valuation report will reflect the enterprise’s underlying financial performance rather than the desires of management, I believe that the starting point should be the entity’s historic statement of cash flows prepared in accordance with FASB Statements Nos. 85 and 117. In other words, what should be relevant is the entity’s historic net cash flows from operating activities; i.e., the net cash flows that the entity will derive from selling goods or providing services to the public. This information should be used as the basis for management’s forecasts or projections so that a well-defined spreadsheet audit trail will exist In the hospital transactions I reviewed, useful historical cash flow information was either not requested or ignored.6 1 The second principal difficulty in business enterprise valuation is selecting the appropriate discount rate. In theory, the discount rate should reflect the industry’s weighted average cost of capital. The transactions I reviewed (see Appendix B, the technical appendix to this chapter) reflected a considerable range of discounts: the lowest was 7.4% (Centinela Valley Health Services) and the highest was 18% (Queen of Angels).6 2 In some instances, the valuation analyst articulated a reason for a particular discount rate; in other cases, a discount rate was selected and applied without any discussion. There ought to be some discussion of the selection of the discount rate. Moreover, an appropriate sensitivity analysis should shown in matrix form so that die 59 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. impact of the discount rate on business enterprise value is clearly demonstrable. No valuation report contained a sensitivity analysis. The third principal difficulty in business enterprise valuation is the concept of “terminal value” and its underlying assumptions. Rarely do forecasts or projections extend beyond ten years, and five years seems to be prevalent in valuation practice. In the case of a five-year forecast or projection, the assumption is that the cash flows (CF) for years 6, 7, .... o o can be derived from the cash flow for year 5 plus an assumed growth rate, or. This means that, in the case of a five-year forecast or projection, the enterprise’s “terminal value” (TV) is given by: Thus, for valuation purposes an enterprise’s terminal value depends upon the growth rate of future cash flows, g , and the discount rate, /. Because terminal value is such a large component of business enterprise value, the effect of changes in the discount rate and cash flow growth rate should be shown. For example, in the case of Riverside Community Hospital, management assumed that the terminal value growth rate, g, would be 4%. But in the cases of Centinela Hospital and Queen of Angels (see Appendix B, the technical appendix to this chapter), a zero growth rate was used. In the case of Sharp Hospital (technical appendix), terminal values were computed using growth rates of 4%, 10%, 12%, and 16%. In almost all the cases, there CFn , = CFj(l + g), for t = 5, 6. ...oo. 60 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. was no sensitivity analysis so that the reader could not discern the effect of changes in the discount rate or the growth rate on overall business enterprise value. In addition, one might wish to know how critical is the analyst’s estimate of business enterprise cash flows for die years 1,..., 5 to the determination of total business enterprise value. Or, to state the problem differently, given any discount rate, /, and forecast length, T years, what proportion of the enterprise’s total value is likely to be due to the analyst’s cash flow forecast or projections and what proportion is likely to be due to a terminal value calculation by formula? If it is likely that a forecast or projection method will make a substantial contribution to the total value of die enterprise, then it would seem prudent to attempt to develop improved cash flow forecasting and projection techniques.6 3 The central problem with business enterprise valuation is that a “point” estimate of value is almost impossible to obtain. The various definitions of cash flow, the difficulty of determining the appropriate discount rate, and the “constant growth” annuity terminal value assumption mean that valuation is more art than science. The vagaries of the discounted cash flow method and the difficulty of tracing management’s forecasts and projections to historical cash flow data necessarily mean that DCF methodology is problematic and prone to valuation error. Nevertheless, it is the “gold” standard for valuation analysis. When DCF methodology is used in conjunction with the comparable transactions and die comparable companies methods, the valuation exercise is likely to be as good as it can be. The potential problems notwithstanding, in the cases I reviewed I saw no evidence of gross hospital enterprise under-valuation or substantial detriment to the public, although financial information was incomplete and none of the valuation reports or opinions had 61 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. been prepared in accordance with generally accepted competency and independence standards applicable to business enterprise valuation engagements.6 4 Of course, the only way to determine the existence of under-valuation (or over-valuation) is by hindsight; i.e., value post-conversion cash flow data for die hospital in question. If this data could be obtained, such a valuation exercise might be worthwhile, especially if the data were to demonstrate that the “for-profit” acquirers actually overpaid for some of their nonprofit hospital purchases.6 5 62 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Chapter 2 1 See Judith E Bell, Hany M . Snyder, and Christine C. Tien, The Public Interest in Conversions o f Nonprofit Health Charities (New York: Consumers Union, 1997). See also Eleanor Hamburger, Jeanne Finberg, and Leticia Alcantar, “ The Pot of Gold: Monitoring Health C are Conversions Can Yield Billions of Dollars for Health Care,” Clearinghouse Review 473 - 5 04 (August-September 199S ). 2 Calif. Corp. Code §§ S914 - S925 (Deering’s), effective for transactions on or after January I, 1997. A m endm ents were m ade in 1999. 3 Calif. Corp. Code § 5917(c) (Deering’s 2000). 4 See, e.g., 26 Code of Federal Regulations § 1.170A-1 (c)(2)(2000) (income tax) and 26 Code of Federal Regulations § 20.203l-l(t>X2000) (estate tax). 5 The “Revenue-Equivelence Theorem” is the result of William Vickrey’s work on auctions. T he theorem states that “open” or “ public” auctions and “secret” or “sealed-bid” auctions are equally good from the seller’s perspective. A corollary is that increasing the number of bidders increases the revenue to the seller, and that the seller’ s revenue will be maximized when the number of bidders approaches infinity. See Louis Phlips, The Economics o f Imperfect Information (Cambridge: Cambridge University Press, 1988), ch. 4, and R. Preston M cA fee and John McM illan, “Auctions and Bidding,” 25(2) Journal o f Economic Literature 699 - 738 (June 1987). 6 Jeremy Bulow and Paul Klemperer, “Auctions Versus Negotiations,” 86(1) American Economic Review 180-191 (March 1996). 7 1 1 California Code of Regulations § 999.5(eX3)(DX2000). 8 Michael A. Diamond, Financial Accounting 4* ed. (Cincinnati: South-Western College Publishing, 1996), p. 31. 9 James J. Unland, The Valuation o f Hospitals & Medical Centers (Chicago: Probus Publishing Company, 1993), pp. 9 - 1 0 . 1 0 Conversation with Paul Conn, Charles Dunn Company, the selling real estate broker. The buyer of the old Q ueen of Angels facility was Bethel Temple of Los Angeles, a nonprofit religious corporation, and the grant deed was recorded in the Los Angeles County Recorder’ s Office o n August 28, 1 9 9 S as instrument number 95-1399962. 63 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 1 James J. Unland, The Valuation o f Hospitals & Medical Centers (Chicago: Probus Publishing Company, 1993), p 1 9 . 1 2 See Robert T. Kauer and J. B . Silvers, “Hospital Free Cash Flow," 16(4) Health Care Management Review 67 - 78 (1991), and Judson T. Bergm an and Brett J. McIntyre, “Valuation Analysis," 15(4) Topics in Health Care Financing 32 - 40 (1989). 1 3 Stephen V . Witman and Richard A. Speizman, “Valuation Issues Pertaining to Not-For-Profit Health Care," 3(1) Valuation Strategies 20 (Sept/Oct. 1999). 1 4 Both valuation services maintain websites that sell public and private transactional information. See www.bvresources.com and www.levinassodates.com. 1 3 See Aswath D am odaran, Investment Valuation (New Y ork: John Wiley & Sons, 1996), and Damodaran on Valuation: Security Analysis fo r Investment and Corporate Finance (John Wiley & Sons, 1994). See also J. Fred W eston, Kwang S. Chung, and Juan A. Siu, Takeovers, Restructuring and Corporate Governance, 2 " * ed. (Upper Saddle River, NJ: Prentice Hall, 1998). 1 6 Irving Levin Associates, Inc.. The Hospital Acquisition Report, 4* ed. (New Canaan, CT: Irving Levin Associates, 1998), p. 6 (Chart 6). Hereafter cited as Irving Levin Associates. 1 7 For an explanation of EBITDA, see Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried, The Analysis and Use o f Financial Statements, 2* d ed. (New Y ork: John Wiley & Sons, 1998). 1 8 In theory, the value of an asset (SV) is equal to the present value of the asset’s stream of future income. If the income stream of SI will last indefinitely and the appropriate discount rate (i) will never vary, then the present value of the stream of income is simply Sl/i. This is the present value of a perpetuity or an annuity whose payments will be m w fe annually and continue forever. See Ernest Brown Skinner, The Mathematical Theory o f Investment, rev. ed. (Boston: Ginn and Company, 1924). N ow if SV =Sl/i, then it is true that i =SI/$V. The ratio of EBITDA (SI) to purchase price (SV) yields the interest or perpetuity capitalization rate. The reciprocal of the capitalization rate is merely the ratio of purchase price to EB ITD A . 1 9 See Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried, The Analysis and Use o f Financial Statements. 2 a d ed. (N ew York: John W iley & Sous, 1998). 2 0 See United States General Accounting Office, Report to Congressional Requesters, “Not-For- Profit Hospitals: Conversion Issues Prom pt Increased State Oversight," GAO/HEHS-98-24 (December 1997), p. 9. 2 1 David T. Bowerman, “A Primer on the Valuation of Health Care Entities," 1(6) Valuation Strategies 1 2 (July/August 1998). See also Irving Levin Associates, p. 1 3 , “For a number of years, the consensus was for buyers to be willing to pay between five and seven times EBITDA to purchase a hospital" 64 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2 2 Krishna G. Palepu, Victor L. Bernard, and P aul M . Healy, Business Analysis < £ Valuation: Using Financial Statements (Cincinnati; Soutb-W estem Publishing Co., 1996), p. 7 etseq. 2 3 See Simon Z. Benninga and Oded H. Sarig, Corporate Finance: A Valuation Approach (N ew York: The McGraw-Hill Companies, 1997). 2 4 See American Hospital Association, “A Profile of Metropolitan Hospitals 1991-95” and “A Profile of Nonmetropolitan Hospitals 1991 -9 5 ” (Chicago: American Hospital Association, 1997). 2 5 Irving Levin Associates, pp. 6 - 1 2 (Charts 6,8,9, and 10 ). 2 6 Source: Compustat PC Plus, produced July 1 6 , 1 9 9 8 for Standard & Poor's Research Insight, © 1 9 9 8 the McGraw-Hill Companies. 2 7 Ibid. 2 8 See, e.g., Aswath Damodaran, Investment Valuation (New York: John Wiley & Sons, 1996). 2 9 For an extensive theoretical treatment, see Jack Hirshleifer, Investment, Interest, and Capital (Englewood Cliffs, NJ: Prcntice-HaU, Inc., 1 9 7 0 ). 3 0 D C F methodology embraces two distinct mathematical approaches: determining the net present value of a series of cash flows (i.e., determining die net present value of a series of costs and benefits— referred to as the “net present value approach”), and determining a project’ s internal rate of return (i.e., determining the interest rate such that the present value of a project’ s costs is identical to the present value of a project’ s benefits— referred to as the “internal rate of return approach”). Although the net present value approach also leads to a unique answer, the internal rate of return approach can harbor multiple (and n«gi« » < tin g ) mathematical solutions. Consequently, given multiple investment or project opportunities pi. Pi. ■ ■ ■ . P m the solution to the optimal investment decision is to always undertake die project with the largest net present value instead of the project with die largest internal rate of return (Solomon, 1959; Hirshleifer, 1970; Clark et al., 1984). Although it is possible for both the net present value approach and the internal rate of return approach to select the sam e investment or project opportunity, it is also possible for die internal rate of return approach to give rise to a technically incorrect choice. T he net present value approach and the internal rate of return approach are equivalent only under limited conditions (Mao, 1969; Clark et al., 1 9 8 4 ). 3 1 Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Va lue of Companies. ed. (New York: John Wiley & Sons, 1996). 3 2 Jack Hirshleifer and Amihai Glazer, Price Theory and Applications. 5* ed. (Englewood Cliffs, NJ: Prentice Hall, 1992). Managers in the public sector have long used cost-benefit or discounted cash flow (DCF) decision-making techniques. See, e.g., William C. Apgar and H . James Brown, Microeconomics and Public Policy (Glenview, IL: Scott, Foresman and C o., 1987), and Robin W . Boadway and David E Wildasin, Public Sector Economics, 2*1 ed. (Boston: Little, Brown and Co., 1984). Thus, in both the private and the public sector the goal 65 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. is the same: the efficient use and allocation of scarce economic resources. For applications of D C F methodology in the public sector, see Edith Stokey and Richard Zeckhauser, A Primer for Policy Analysis (New York: W . W. Norton & C o., 1978). 3 3 See, e-g., Simon Bennmga, Financial Modeling (Cambridge, MA: MIT Press, 1997), p. 1 8 . For a definition of “free cash flow” in the context of hospital analysis, see Robert T. Kaner and J. B . Silvers, “Hospital free cash flow,” 16(4) Health Care Management Review 67-77 (Fall 1991). 3 4 Robert T. Kauer and J. B . Silvers, “Hospital Free Cash Flow,” 16(4) Health Care Management Review 67-78 (1991). 3 5 The terminology can be confusing. The term “enterprise” encompasses both business enterprises and nonprofit or not-for-profit organizations. Business enterprises issue to their creditors and owners a statement o f net income; nonprofit organizations issue to their creditors and donors a statement o f operations or a statement o f activities. Both business and nonprofit enterprises are required to issue a statement o f cash flows. See Financial Accounting Standards Board, Current Text: Accounting Standards as o f June I. 1997, vols. I & D (Norwalk, C T: FA SB , 1997), Sections C 25 (vol. I) and No 5 (vol. D ). 3 6 Illustrative financial statements for both nonprofit and for profit hospitals, including cash flow statements, are contained in the AICPA Audit and Accounting Guide, Health Care Organizations (New Y ork: American Institute of Certified Public Accountants, 1997). 3 7 R ay G. Stephens and Vijay Govindarajan, “On Assessing a Firm’s Cash Generating Ability,” 65(1) Accounting Review 242-257 (January 1 9 9 0 ). 38 Strictly speaking, in the accounting literature a financial forecast represents what management expects to happen in the future based upon what has happened to die existing business in the past A financial projection, on the other hand, is based upon one or more hypothetical assumptions to reflect what management thinks could happen if certain events or circumstances were to actually occur. 3 9 See, e.g., Simon Bennm ga, Financial Modeling (Cambridge, MA: The M IT Press, 1997), and Sim on Z. Benninga and Oded H . Sang, Corporate Finance: A Valuation Approach (New York: McGraw-Hill Companies, Inc., 1997). 4 0 Francis X. Diebold and Jose A. Lopez, “Forecast Evaluation and Combination” (Cambridge, M A : National Bureau of Economic Research, Inc., Technical Working Paper 192, March 1996). 4 1 Kenneth S. Lorek and G . Lee Willinger, “A Multivariate Time-Series Prediction M odel for Cash-Flow Data,” 71(1) Accounting Review 81-101 (January 1996). 4 2 Steven N. Kaplan and Richard S. Ruback, “ The Valuation of Cash Flow Forecasts: An Empirical Analysis, 50(4) Journal o f Finance 1059-1093 (September 1 9 9 S ). The authors reviewed S1 publicly reported management buyouts completed between 1 9 8 3 and 1989. 66 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4 3 For some insights into using FASB Statement No. 95, see Ray G. Stephens and Vijay Govindarajan, “On Assessing a Firm’s Cash Generating Ability,” 65(1) The Accounting Review 242 - 257 (January 1990). 4 4 Gary Smith, Statistical Reasoning. 2 f* ed. (Boston: A O yn and Bacon, 1988), ch. 1 8 . 4 5 Francis X. Diebold and Jose A. Lopez, “Forecast Evaluation and Combination” (Cambridge, M A : National Bureau of Econom ic Research, Inc., Technical Working Paper 192, March 19%). 4 6 Assume an initial amount (S B ) will grow at the rate of g% per annum and that die applicable discount rate is i% per annum. Then the present value (P)ofa growing perpetuity is: v y ysaa+gr 1 . % b | sio + g ) 1 t $*(i+g)2 | t s ip +gr ' sb tr o+o' o+o o+o 2 o+o 3 " o+o* (/-* )’ for i > g- In order for the infinite series to converge, die discount rate must exceed the annuity’s fixed growth rate. This is referred to as the “constant growth” model because the growth rate (g) remains constant over die life of the annuity. It should be noted that: Sfio+g) / - I 1 1* 6 0+0' o+o5 5 \ In other words, the value of a growing perpetuity that is to commence five years in the future can be determined by using the sixth period’s cash flow as the initial value of a growing perpetuity and then discounting the result to the present. The constant growth perpetuity model is used by Damodaran (1997), Weston, Chung, & Shi (1998), Palepu, Bernard, & H ealy (19%), Brealey & Myers (1996), Copeland & W eston (1988), Ross, Westerfield, St Jaffe (19%), and Bcmringa St Sarig (1997). The genesis of these and other valuation models is Williams (1938). 4 7 Variable growth annuity models do exist but in practice, they are clumsy and awkward to use. 4 8 See Avinash K . Dixit and Robert S. Pindyck, Investment Under Uncertainty (Princeton, NJ: Princeton University Press, 1 9 9 4 ). 4 9 See, e.g., Cyril Tomkins, Corporate Resource Allocation: Financial. Strategic, and Organizational Perspectives (Oxford: Basil Blackwell, 1991); Harold Bierman & Seymour Smidt, The Capital Budgeting Decision: Economic Analysis o f Investment Projects, 8* ed. (Upper Saddle River, NJ: Prentice Hall, 1993); and Edward W . Davis St John Pointon, Finance and the Firm (Oxford: Oxford University Press, 1984). 67 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5 0 See, e.g^ Aswath Dam odaran, Corporate Finance: Theory and Practice (N ew York: John W iley & Sons, Inc., 1997); and Stephen A. Ross, Randolph W. Westerfield, & Jeffrey Jafie, Corporate Finance. 4* ed. (Chicago: Irwin, 1996). 5 1 The rate is asstimed to be a constant because everyone is deemed to hold the “same certain expectations about the future” (Nickel!, 1978, pp. 6 - 7). This "perfect capital market” assumption greatly simplifies the determination of BEV. If the discount rate w ere permitted to vary over time, then die continuous-time valuation formula must be adjusted. For a discussion of variable discount rates, see Allen (1967) and Nickell (1978). An important issue, therefore, is whether or not a variable discount rate would exert a material valuation influence. In business enterprise valuation, the effect of a variable discount rate is arguably im m aterial. Recently, W eitzm an (2001) has proposed incorporating a probability distribution directly into die discount rate analysis to resolve discount rate uncertainty. 5 2 California Attorney General Press Release No. 97-043 (April 22,1997). 5 3 The mid-year discounting convention is discussed and illustrated in Simon Z. Benninga & O ded H. Sarig, Corporate Finance: A Valuation Approach (New York: The McGraw H ill Companies, Inc., 1997). 5 4 For a m ore complete mathematical explanation, consult Appendix B (Technical Appendix to Chapter 2). 5 5 The "no growth” perpetuity valuation model is V alu e = income + interest rate. 3 6 A m ore sophisticated m ethod of using DCF analysis relies on continuous time modeling techniques. In continuous tim e economics, suppose the business enterprise’s net operating cash flow at any time is given by fit). Then the present value of die operating cash flows (and hence the value of the business enterprise) is given by the definite integral 0 where / denotes the approp riate discount or interest rate (actually, the investor’ s desired rate of return) and n denotes die duration or horizon of the investment (Nicholson, 1 9 9 2 ; Allen, 1938, pp. 4 0 1 - 404). The cash flow function/ft) may be linear, quadratic, logarithmic, exponential, or even sinusoidal. A sinusoidal model has the advantage of being able to capture cyclic or oscillatory behavior in an enterprise’s net income or cash flows and it can also exhibit increasing or decreasing growth. See Robert D. Banks, Growth and Diffusion Phenomena: Mathematical Frameworks and Applications (Berlin: Springer-Verlag, 1994), pp. 224 - 240. A variety of continuous functions can be used provided there is empirical support for a particular function’s use and fit)e* is integrable. The law of diminishing returns suggests that an enterprise’s cash flow will grow or increase over time but at a decreasing rate of growth; Le.. 68 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. f(t) > 0 but f ” (t) < 0. The range of integration can be [0, n] or [0, « c j, but in the case of a “going concern" it is the usual practice to let a approach < » because the enterprise is assumed to have an infinite life. If the limits of integration are [0, < * > ] , then the im proper integral must converge. Mathematically, the result is die Laplace transform of fit). See Richard K. Miller, Introduction to Differential Equations, 2*1 ed. (Englewood Cliffs, NJ: Prentice-Hall, Inc., 1991), ch. 6. Using the method of least squares and the data shown in Table 6, it is easy to derive the following linear timc-scries trend equation: fit) = $2,826.000 + (S1.263.400)L Using the present value integral shown above, the value of Riverside Community Hospital is easily determined to be: J / ( / ) e - 0l6'<a = $67,014,100. o The discount rate (i = 1 6 % ) is the same that was used before. Although the figure of $67 million is considerably more than die Ernst & Young figure of $59 or $60 million, the $67 million figure is very close to the actual purchase price of $70.5 million. In practice, it m ay be difficult to obtain a sufficient number of data points to make this method useful. Moreover, if the slope of the time series is negative the results can be nonsense. Under certain circumstances, combining the enterprise’s historical, pre-acquisition cash flows with management’ s estimate or forecast of the enterprise’s post-acquisition cash flows may be useful. The common problem with all business valuation models is that they attempt to forecast future cash flows on the basis of limited prior (time-series) data— frequently the last five years of earnings data. Earlier earnings periods, if they exist, are oflen ignored so that there is always the possibility of intentionally or unintentionally m ask in g or altering disturbing economic trends. Thus time series cash flow forecasts tend to be simplistic mechanical extrapolations without the benefit of any real behavioral or causal model. Although we would like to be able to build an explanatory model, measure initial empirical data, and use the model to predict the future, both model complexity and the cost of acquiring initial data would seem to make the performance of this task impossible. This explains why “bare bones’ * tim e series models are widely used: they are simple to construct and easy to use for prediction purposes. 5 7 BEV examples using short-term (i.e., 1 0 years or less) management cash flow forecasts or projections appear in Benninga (1997), Bennmga & Sarig (1997), Copeland, Roller, & M urrin (19%), Damodaran (1997, 19%, 1994), Gaughan (1999), Pratt, Reilly, & Schweihs (2000), and Weston, Chung, & Siu (1998). 5 8 See, e.g., H . Nejat Seyhun, “Do Bidder Managers Knowingly Pay Too M uch for Target Firms?" 63(4) Journal o f Business 439-464 (October 1990); Randall Morck, Andrei Shleifer, & Robert W . Vishny, “Do Managerial Objectives Drive Bad Acquisitions?” 45(1) Journal o f Finance 31- 69 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 48 (March 1990); and Bernard S. Black, “Bidder Overpayment in Takeovers,” 41 Stanford Law Review 597 (February 1989). 5 9 John B. Canning, T h e Economics o f Accountancy (New York: The Ronald Press, 1929), pp. 197 - 207. 60 American Institute of Certified Public Accountants, Guide For Prospective Financial Statements (New York: American Institute of Certified Public Accountants, 1986). 6 1 As originally promulgated, FASB No. 95 did not apply to not-for-profit organizations. FASB No. 117, issued in June 1 9 9 3 and effective for fiscal years beginning after Decem ber 15, 1994, extended FASB No. 9 5 to not-for-profit organizations. Yet, by 1990 the handwriting was on the wall due to the existence of earlier task force reports and exposure drafts. 6 2 The following discount rates were used: Riverside Community Hospital, 16 % ; Pacific Hospital of Long Beach, 20% ; Centinela Valley Health Services, 8.4% (average); Sharp HealthCare, 13.9% (average); Q ueen of Angels, 18% . 6 3 Mathematically, if fit) denotes the function that defines management’s cash flow forecast or projection for a period of T years and gft) denotes the function that defines die enterprise’s residual or post-forecast cash flows, then business enterprise value (BEV) is: BEV = \f(t)e -adt+\g(t)e-udt. o T A person who is doing business enterprise valuation should warn to know something about the relative importance of each component to the determination of BEV. If the functions 7ft) and gft) are specified, it is possible to quantify the relative contribution of each component 6 4 See, e.g., Frank C. Evans, “Tips for the Valuator,” 189(3) Journal of Accountancy 35 - 4 1 (March 2000). 6 3 See, e.g., Steven N. K aplan and Michael W . W eisbach, “ The Success of Acquisitions: Evidence from Divestitures,” 47(1) Journal o f Finance 107-138 (March 1992). 70 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 3 Use o f C haritable Proceeds 3.1 Introduction When a nonprofit community hospital is sold to a “for-profit” hospital corporation, federal and state law requires that the sales proceeds be set aside and remain in charitable solution (indefinitely) under the statutory or common law jurisdiction and supervision of the State Attorney General. By either statute or common law, and with such deviations as a court of competent jurisdiction may permit, the hospital sales proceeds are required to be used for charitable purposes that are consistent with or similar to the selling hospital’s historic charitable purposes. In California, for example, the relevant statutes state that the proposed use of the sales proceeds must be “consistent with the charitable trust on which the assets [were] held by the [selling] health facility. . . ” 1 It is against this backdrop that the principal questions or critical issues are straightforward: who should receive the sales proceeds or monies, who should manage die proceeds, and how should the proceeds be spent or used?2 Unfortunately, the answers to these questions are not necessary straightforward. This chapter discusses these questions and offers some policy recommendations. First, however, it is necessary to consider the magnitude of the financial management problem. 71 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.2 Hospital Conversion Endowments As several commentators and policy makers have pointed out, the sale of non profit community hospitals to “for-profit” hospital chains has resulted in billions of dollars becoming available for a variety of charitable health care related purposes. Unfortunately, due to incomplete information and misinterpretation, some of the charitable accounting has been seriously muddled. For example, a common error is to assume that die amount of charitable set-aside will be equal to the publicized cash purchase price when, in feet, the selling nonprofit hospital may be required to use some of the purchase cash to pay outstanding liabilities not assumed by the “for-profit” purchaser. Another error is to confuse the publicized purchase price with the amount of cash that the selling nonprofit hospital may actually receive; i.e., if the purchase price includes the seller’s liabilities assumed by the “for-profit” purchaser, the cash proceeds must be reduced by the amount of the assumed indebtedness. According to a recent survey by Grantmakers in Health, since 1981 at least ninety- four new or existing charitable organizations throughout the United States have been partially or wholly funded by proceeds derived from the sale of non-profit community hospitals.3 Table 9 (below) shows that substantially all of the hospital sales occurred during the 1 990s and that, in the aggregate, these charitable organizations had assets (as of December 31,2000) in excess of $7 billion dollars: 72 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 9: Assets of Charitable Organizations Fonded by Natioawide Hospital Coaversioas Year Number of Hospital Conversions Year2000 Assets Before 1990 25 $1,745,417,379 1990-1995 30 $3,059,115,769 1996 - 2000 39 $2,600,913,050 Total 94 $7,405,446,198 Mean assets $78,781,342 Source: Grantmakcrs in Health, “A Profile of New Health Foundations’ * (March 2001). The above data includes proceeds of approximately S70S million from the sale of nine California non-profit community hospitals, of which the valuations o f three (Riverside Community Hospital, Queen of Angeles—Hollywood Presbyterian Medical Center, and the Good Samaritan Health System) are discussed in this dissertation.4 Financial information from the 1999 study by Consumers Union on the status of eleven hospital conversions in California from 1993 through 1998 is relevant5 TablelO (below) shows the purchase prices and the mandatory charitable set-asides or conversion endowments for the six hospitals discussed in this dissertation: With the exception of United Western Medical Centers, the purchase price information shown in the Consumers Union report (Table 10) agrees with the purchase price information I obtained from the attorney general’s public transaction file (Table 2, Chapter 1). For United Western Medical Centers, however, Consumers Union reported a purchase price of SI85.0 million; my calculation from the Attorney General’s public file (Table 2, Chapter 1) is approximately $177.4 million. The difference appears to be 73 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. attributable to the value of a nursing home subsidiary, which Consumers Union inchided but I excluded from die hospital sales transaction. Table 10: Assets o f Charitable Organizations Funded by California Hospital Conversions Converting Hospital Year Purchase Price Conversion Endowm ent Good Samaritan Health System 1 9 9 5 $165.0 million $71.0 million Centinela Valley H ealth Services 19% S%.8 million $50.0 million Pacific Hospital of Long Beach 19% $5 J million $5.5 m illion United Western M edical Centers 19% $185.0 million $29.0 million Queen of Angels 1997 $86.4 million $277.0 m illion Riverside Community Hospital 1 9 9 7 $70 .5 million S22.4 m illion Mean conversion endowment $67.4 m illion Source: Consumers Union, “White Knights or Trojan H orses’ * (April 1999), Tables 4 & 6. Table 10 reflects a substantial gap between the hospital’s purchase price and the amount of the mandatory charitable “set-aside” or conversion endowment The difference is due to indebtedness that was required to be extinguished by the selling nonprofit hospitals or assumed by the “for-profit” purchasers plus pre-existing charitable funds, if any. For example, although Centinela Valley Health Services sold Centinela Hospital to a “ for-profit” subsidiary of Omda HealthCorp for approximately $96.8, that price included liabilities assumed by the “for-profit” purchaser (approximately $75.8 million) so that the selling hospital received only $21 million in cash (approximately). Consumers Union reported the total amount attributable to the conversion endowment to be $50 million (Table 10, above) but only $21 million came from the actual sale o f die hospital; the other 74 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. $29 million had been previously received by die hospital from the public as donations to be used for charitable (hospital-related) purposes.6 Table 10 also shows United Western Medical Centers’ conversion endowment to be $29 million. My calculation is $47 million.7 The difference is probably due to post closing changes in the amount of liabilities assumed by the purchaser or paid by the selling nonprofit hospital corporation. Unfortunately, I cannot tell because at the time of my review the public transaction file was incomplete and it did not contain die financial effects o f these changes. Almost all asset sale agreements permit post-closing purchase price adjustments to account for changes in net working capital, long-term liabilities, and capital expenditures.8 Finally, Table 10 indicates that Queen of Angels was sold for $86.4 million but that somehow it managed to provide a charitable “set-aside” or conversion endowment of $277 million.9 On its face, this would be a financial impossibility. The explanation is twofold. First, under the terms of the asset purchase agreement, in addition to the cash price of approximately $86.4 million. Tenet is obligated to remit to Queen of Angels the value of certain state discretionary grants estimated to be worth an additional $45 J million (for a total purchase price of $131.7 million). Second, the $277 million figure includes previously accumulated charitable or restricted assets of approximately $167 million.1 0 In California, it is important to recognize that the aggregate charitable proceeds from hospital conversion set-asides represents a very small fraction o f California’s total charitable wealth. To put hospital conversions into perspective, the aggregate asset purchase price for the hospitals shown in Table 10 is less than $ 1 billion. Many people fail to realize that there are more than 80,000 registered charities operating in California with 75 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. total reported charitable assets in excess of $200 billion." These figures exclude nonprofit schools, hospitals, and religious institutions because their registration with the California Attorney General's office is not required.1 2 The assets of California’s healthcare conversion foundations amount to approximately S7 billion or less than 5 percent of all reported charitable assets in the state.1 3 Consequently, the magnitude of the hospital conversion asset management problem appears to be overstated, although the proper management of charitable monies for a community’s benefit, from whatever source derived, is an important and legitimate public policy concern. 33 Who Should Receive the Proceeds? The common law of charitable organizations (whether incorporated or unincorporated) requires that all charitable assets be held in trust for charitable purposes indefinitely.1 4 A nonprofit organization’s charitable purposes are required to be specified by the organization’s organizers, who are usually the initial directors or trustees named in the organization’s creating or governing document These purposes may be broad or narrow. The technical appendix to this chapter discusses the charitable purposes for most of die six hospitals discussed in this dissertation. Almost all commentators and policymakers have assumed, perhaps erroneously, that since the proceeds from the sale of a non-profit community hospital are required to remain in charitable solution indefinitely, the proper recipient is either an existing or a newly formed tax-exempt charitable organization.1 5 This assumption stems principally from the federal income tax law of tax-exempt charitable organizations, since federal law 76 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. generally requires that upon dissolution die assets of a tax-exempt charitable organization be transferred to a pre-existing or newly formed successor tax-exempt charitable organization.1 6 The same income tax regulations, however, permit the assets of a dissolving tax- exempt charitable organization to be transferred to the federal, state, or local government for public purposes. In other words, the directors or trustees of a tax-exempt charitable organization have a choice: they may transfer the proceeds from the sale of a non-profit tax-exempt hospital to an existing or newly formed tax-exempt charitable organization to be held and managed for charitable purposes similar to the transferee’s historic charitable purposes or mission, or they may transfer the sales proceeds to federal, state, or local government for public purposes. Thus, the law of tax-exempt charitable organizations (both common law and federal tax law) permits the nonprofit sector to manage what would otherwise be a government spending decision. 3.3.1 Transfer o f Proceeds to Government Although eschewed by large charitable organizations for reasons of obvious agency (self-interest) considerations,1 7 the notion that the proceeds from the sale of non profit community hospitals should be returned to federal, state, or local government for public use is entirely consistent with the concept of tax expenditures and existing federal law. Under the tax expenditure concept, the deductibility by donors of charitable contributions to non-profit hospitals, federal and state income tax exemptions, and local property tax exemptions represent disguised budgetary expenditures because taxpayers could pay their tax liabilities in full and governments could budget direct expenditures to 77 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. build, operate, and maintain community hospital facilities.1 8 Since tax expenditures are the equivalent of direct governmental spending,1 9 there is no reason not to require the proceeds from the sale of community hospitals to be returned to government for public spending purposes. The principal objections to government control appear to be threefold. First, there is the objection that government may spend the windfall monies imprudently,2 0 but then there is always some objection to almost all government spending.2' Unfortunately, in die absence of appropriate decision-making safeguards, which I shall discuss later in this chapter, there is no assurance that privatization of the spending decision will lead to a Pareto-optimal outcome. Second, there is the objection, voiced by Consumers Union, that since the assets of the nonprofit selling hospital were created in the “private nonprofit sector,” to sanction government control over the sales or conversion proceeds would be to violate the charitable trust doctrine.2 2 This objection, however, overlooks the tax expenditures concept and die use of federal funds to construct or improve nonprofit community hospitals. Finally, there is the objection that it would be administratively difficult to ascertain the precise amount of federal, state, and local tax expenditures, but estimates from public tax records could be made. It appears that some commentators and policy makers may have neglected federal hospital law. Under existing federal law, when a non-profit hospital is sold there is no mandatory asset valuation and charitable set-aside. Instead, under the provisions of the Hill-Burton Act,2 3 the United States has the right to recover or recapture, with interest, any public monies used to construct or modernize a public or non-profit hospital if the hospital is sold to a “for profit” enterprise within twenty years after completion of construction or 78 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. modernization.2 4 This recapture right even extends to subsequent transferees so drat any person in the chain of title within die twenty-year statutory recovery period can be assessed.2 5 After twenty years, however, the right to reimbursement is lost2 6 Presumably, the government will have received its quid pro quo if the hospital remains in a non-profit’s hands for a twenty-year period. Although the Hill-Burton Act is no longer being funded and the mandatory recovery period appears to have expired in 1994,2 7 the Act suggests that there would be no legal infirmity to requiring, as a matter of law, that the proceeds from the sale of a non profit communit99y hospital be returned to federal, state, and local government in proportion to the amount of each government’s subsidy. The federal government could be accorded priority to the extent of its Hill-Burton recapture claim, followed by state and local government interests. Unlike present law, there would be no statutory limitation on the government’s recapture right Admittedly, the principal difficulty is determining the amount of revenue forgone due to state income and local property tax exemptions: without extensive historical cost accounting records, as well as information about estimated tax expenditures, it would be difficult perhaps impossible, to determine an appropriate reimbursement figure. Nevertheless, this difficulty is no reason to reject the recapture concept In the absence of appropriate tax expenditure information, state and local governments could be permitted to share the sales proceeds equally. With the sales proceeds in the hands of government for general spending purposes, the usual resource allocation mechanisms, including the theory of public choice, would come into play.2 8 79 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.3.2 Transfer o f Proceeds to Charitable Organizations In the absence of a policy of mandatory government recapture, hospital sales proceeds will continue to be received by existing or newly formed tax-exempt charitable organizations that will be responsible for managing the funds and spending them for appropriate (health care related) purposes.2 9 Most hospital conversion transactions have been structured as asset purchases for cash, which means that, having ceased to become an “operating” hospital by virtue of the sale or transfer of its hospital assets to a “for-profit” acquiring company, the historic non-profit hospital corporation will nevertheless remain a tax-exempt entity that will be obligated to make cash distributions for health-related charitable purposes.3 0 The mechanics of the conversion transaction, the preferences of the hospital’s directors or trustees, and tax planning strategies will usually dictate whether the sales proceeds should be retained by the selling charitable organization or whether they should be transferred to a newly formed or a previously existing charitable organization. Since most hospital conversions are structured as asset sale transactions, the selling nonprofit hospital will remain in existence and continue to use the conversion proceeds for charitable purposes (albeit under the Attorney General’s direction). If the selling nonprofit hospital corporation remains in existence, the central question will be whether to exist as a “public charity” or a “private foundation.” Of course, the selling corporation may effectively dissolve and distribute the conversion proceeds to another charitable organization.3 1 For example, if the amount of net sales proceeds ultimately retained by the selling charitable hospital organization is relatively small,3 2 the board is disinterested in fund management, or the board lacks fund management expertise, it may be expedient to 80 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. voluntarily dissolve the charitable corporation and allow a larger existing charitable organization to manage the monies as required by law. If the amount o f net sales proceeds is relatively large and the directors or trustees of the selling non-profit hospital are interested in fund management and have the requisite expertise, die former hospital operating corporation may continue its existence as a charitable organization that promotes health. The following scenarios illustrate some o f the pertinent mechanics of disposing of the proceeds of hospital sales or conversions: 1 . H, a nonprofit public benefit or charitable corporation, owns and operates a community hospital. For good and sufficient reasons, the board of directors decides to sell the hospital to a “for-profit” hospital chain for cash. After all debts are paid, H will have SlOQx cash (and no other assets) available for health care related charitable purposes. H 's directors or trustees want to retire from all activity. Result; subject to the approval of the attorney general and a court of competent jurisdiction, H may voluntarily dissolve and in the course of dissolution transfer the SlOQr cash to an existing health care or other charitable organization to be used by the transferee for specified health care purposes. The transferee may be either a public charity or a private foundation,1 3 For example, after selling Centinela Hospital Medical Center, the directors of Centinela Valley Health Services, which owned the hospital, decided to merge the selling 81 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. nonprofit hospital corporation with and into the California Community Foundation, an existing public charity. The effect of the merger was to transfer all of the selling hospital’s assets (i.e., the net conversion proceeds) to the California Community Foundation. The California Community Foundation is obligated to maintain the conversion proceeds as a separate fund and distribute the income, after management expenses, to other qualifying charitable organizations for specified community health care purposes. The Foundation may continue to receive contributions from the public that are restricted to the Centinela Hospital fund. The directors o f Riverside Community Hospital, which was sold for cash and a 25 percent equity interest in a “for-profit” hospital company, decided to merge the selling nonprofit hospital corporation with and into its nonprofit parent corporation, Community Health Corporation. Thus, Community Health Corporation, a previously existing public charity, now manages the conversion proceeds and it owns a 25 percent equity interest in Riverside Health Systems LLC, the California limited liability “for-profit” company that owns and operates Riverside Community Hospital. 2. G, a nonprofit public benefit or charitable corporation, owns and operates a community hospital. For good and sufficient reasons, the board of directors decides to sell die hospital to a “for-profit” hospital chain for cash (SlOQr) and an equity interest (S5Qx) in a “for-profit” limited liability hospital company. After all debts are paid, G will have $125x (cash and equity value) available for health care related charitable purposes. G's directors or trustees want to remain active in health care philanthropy. Result: subject to the approval of the 82 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. attorney general and a court of competent jurisdiction, G’ s directors or trustees can amend die organization’s articles of incorporation and continue to operate G as either a public charity or a private foundation for health care related purposes. An amendment of corporate articles coupled with a “change of name” is common. Thus, the Good Samaritan Hospital of Santa Clara Valley became “The Health Trust,” a public charity, and Queen of Angels—Hollywood Presbyterian Medical Center became “QueensCare,” another public charity. As public charities, both organizations can expect to continue to receive charitable donations from the private sector for charitable purposes. Pacific Hospital of Long Beach, however, changed its name to the Pacific Hospital of Long Beach Charitable Trust and became a private foundation. It is highly unlikely that the private foundation will receive additional public contributions, although there is no legal impediment. 3. F, a nonprofit public benefit or charitable corporation, owns and operates a community hospital. For good and sufficient reasons, the board of directors decides to sell the hospital to a “for-profit” hospital chain for cash and securities. After all debts are paid, F will have $150tr available for health care related charitable purposes. Some (but not all) of F 's directors or trustees want to remain active in health care philanthropy. Those who want to remain active in health care philanthropy believe that the community should establish and support a new health care charitable organization. Result: If a new health 83 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. care charitable organization is formed, then, subject to die approval of die attorney general and a court of competent jurisdiction, P s directors or trustees can transfer P s assets (SISQx) to the new chanty and then dissolve F. The new charity may be either a public charity or a private foundation. This appears to be the approach taken by the board of directors of United Western Medical Centers. After selling the hospital in 1996, the board of directors agreed to transfer the sales proceeds to the Healthcare Foundation for Orange County, a recently formed California nonprofit public benefit corporation. According to United Western Medical Centers' Internal Revenue Service Form 990 for the year ending March 31,2000, the hospital corporation will be dissolved and its net assets will be distributed to the Healthcare Foundation.1 4 At this time, it appears that the Healthcare Foundation will be classified as a private foundation. In the preceding scenarios, I used italics to emphasize that the charitable organization which receives the hospital sales or conversion proceeds will be classified as either a “public charity” or a “private foundation.” There is one other possibility: the charitable organization may function as a tax-exempt “social welfare” organization. Regardless of the classification, the charitable organization that receives the conversion proceeds will most likely function as a grant-making philanthropic organization which will use the proceeds (principal, income, or both) to benefit one or more specific communities within a defined geographic area. 84 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.3.2.1 S ectio n 501(c)(3) O r g a n iz a t io n s Corporations and trusts organized and operated exclusively for “charitable” purposes are tax-exempt, if at all, under the provisions of Internal Revenue Code § 50l(cX3). A “charitable” organization is not automatically tax-exempt Rather, the organization must submit a formal exemption application to die Internal Revenue Service.3 5 The organization’s governing documents (articles of incorporation or trust agreement) must contain specific operating provisions and restrictions, including language that requires the organization’s assets to be irrevocably committed or dedicated to charitable use.3 6 If the Internal Revenue Service agrees that the charitable organization meets the requirements of section 501(cX3), it will issue a written determination letter. Upon audit, however, if the Internal Revenue Service decides that the organization is not being operated exclusively for charitable purposes, the organization’s tax-exemption will be revoked and the loss of exempt status may be retroactive. The Internal Revenue Code classifies all tax-exempt section 501(cX3) “charitable” organizations as either public charities or private foundations. The distinction is important because “private foundations” are subject to special restrictions and potential excise taxes. Depending upon the level o f post-sale public financial support, a “conversion foundation” may be either a public charity or a private foundation. If a conversion foundation receives broad public support (i.e., more than one-third of its support from public sources), it will be classified as a “public charity.” If it fails to receive broad public support (i.e., one-third or less of its support comes from public sources), it will be classified as a “private foundation.” 85 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. So-called public charities typically include tax-exempt hospitals, colleges and universities, and religious or public safety organizations.3 7 Public charities generally receive broad public support in die form of donations and contributions and the charity itself is unlikely to be dominated or controlled by a group of related individuals. This is certainly true of tax-exempt non-profit community hospitals because such hospitals tend to receive significant public contributions or donations each year and the hospital's board of directors or trustees tend to be individuals who are unrelated to one another.3 8 In general, “private foundations” are tax-exempt, charitable corporations that fail to receive broad public support, that receive substantial investment income in the form of dividends and interest rather than donations or contributions from the public, or that may be governed or controlled by related individuals. The precise statutory definition is by exclusion; i.e., after defining what is a “public” charity, every other charity is deemed to be a private foundation.3 9 After a tax-exempt charitable hospital sells its operating assets, the conversion organization or foundation may fail to receive broad public support After a tax-exempt charitable hospital sells its operating assets, it may no longer be a public charity. In fact it will usually become an organization that merely receives investment income (dividends and interest) from the hospital's sales proceeds and uses principal or income from the proceeds to make grants to other charitable organizations for community health-related purposes. As such, the Internal Revenue Service may classify the organization as a “private foundation” that is subject to special provisions, including the excise tax and mandatory distribution and excess business holding rules.4 0 This appears to be the situation for the Pacific Hospital of Long Beach (the Pacific Hospital of 86 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Long Beach Charitable Trust) and United Western Medical Centers (The Healthcare Foundation for Orange County). Public charities do not pay income tax on their investment income and they are not required to make mandatory distributions of income for charitable purposes. Private foundations, however, are required to pay an annual tax equal to 2 percent o f net investment income and distribute each year for charitable purposes at least 5 percent o f the fair market value of their investment assets.4 1 The excise tax on investment income is unfortunate, but the mandatory distribution requirement should not be troublesome. For example, if the tax-exempt corporation holds SlO O x in assets (cash and securities) from the sale of hospital assets to a “for-profit'’ corporation, it should be relatively easy for the board of directors to distribute at least $5x annually to qualifying charitable corporations for health-related purposes. Since the foundation should expect to earn more than 5 percent on its investment assets, the effect of the mandatory distribution rule is to make certain that each year a minimum amount of the foundation’s annual investment income is always distributed. If the private foundation owns stock or an equity interest in a “for-profit” business (such as a LLC joint venture), a special excise tax may apply in order to force the disposition of the business interest and thus prevent a tax-exempt entity from owning or controlling a “for-profit” business.4 2 The general rule is that a private foundation may not own more than 20 percent of the voting stock of a “for-profit” corporation, and the value of stock in excess of this amount is subject to a 5 percent annual excise tax. Thus, if a non profit hospital were to receive a 50 percent equity interest in a LLC worth S50x, under the general rule the annual excise tax would be $1.5x; i.e., 5% of ($50x - $20x). Because of 87 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. this tax, the foundation's directors or trustees may have an incentive to monetize the foundation’s investment in the LLC as soon as possible. 3.32.2 S ection 501(c )(4) O r g a n iz a t io n s The special excise taxes and other restrictions applicable to private foundations under the Internal Revenue Code make it desirable to avoid “private foundation’ * classification. To escape private foundation status, a conversion foundation (i.e., a foundation arising out of a hospital conversion) may seek to become a tax-exempt “social welfare” organization within tbe ambit of section 501(cX4) of the Internal Revenue Code o f 1986. Although income derived by a “social welfare” organization is tax-exempt, donors may not receive a section 170 charitable contribution deduction for amounts contributed to the organization. If the organization has sufficient assets, the board of directors or trustees may not care that little or no additional contributions will be received from the public. Unfortunately, because of Congressional concern that a private foundation might choose to become a less strictly regulated “social welfare” organization, any change of status must satisfy the special termination rules of section 507 of the Internal Revenue Code of 1986. Under section 507, the Internal Revenue Service has discretion to impose a “termination tax” to recapture the tax benefits that the private foundation and its substantial contributors enjoyed during the foundation’s existence. If the Internal Revenue Service receives assurance that the organization’s assets will be used for bona fide charitable purposes, a section 501(cX3) status organization will be allowed to convert to a section 501(cX4) status organization without any difficulty.4 3 The difficulty of converting to 88 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. section 501(cX4) status may explain why, according to Grantmakers in Health, all hospital conversion foundations have retained their section 501(cX3) status.4 4 Since section S01(cX3) charitable organizations (both “public charities’ * and “private foundations”) are subject to more Internal Revenue Service oversight than section 501(cX4) social welfare organizations, public policy should generally preclude a change in tax-exempt status from occurring.4 3 Because of the long-standing regulatory disparity between “charitable’ * organizations and “social welfare” organizations, in 1996 Congress enacted legislation to equalize and enhance the regulatory oversight of both kinds of organizations.4 6 As a result of this change, the managerial activities of directors and trustees of “charitable” and “social welfare” organizations (especially compensation and remuneration decisions) are subject to greater scrutiny and so there may be somewhat less of an incentive for a “charitable” organization to attempt to convert to a “social welfare” organization. 3.3.2.3 Public Policy Recommendations Of the ninety-three hospital conversion foundations recently profiled by Grantmakers in Health, at least thirty-six were reported to be “private foundations” and die rest were reported to be “public charities.” 4 7 Given the greater scrutiny and the more burdensome restrictions that are imposed upon private foundations under federal income tax law, consumer groups should prefer “private foundation” status to “public charity” status. For one thing, “public charities” are not required to make minimum annual distributions for charitable purposes while “private foundations” are required to make such distributions. A public charity that does not make significant distributions would certainly 89 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. be an aberration and one should wonder why distributions are not occurring. In the absence of compelling circumstances, the requirement of a minimum annual distribution is a sound reason for consumer advocates to prefer “private foundation'* status to “public charity” status. Interestingly, California’s hospital conversion legislation does not contain any requirement that a conversion foundation distribute a certain percentage of its income or principal each year. If an organization is classified as a “private foundation,” California law requires that the organization distribute sufficient income (and principal, if necessary) to avoid the imposition of any federal excise (penalty) tax on undistributed foundation income.4 1 If an organization is classified as a “public charity,” however, there is no state law minimum distribution requirement, which means that the directors of a “public charity” conversion foundation can choose to make no distributions for the community's benefit The principal policy recommendation is that all hospital sales or conversion proceeds should be placed in a charitable organization that is tax-exempt under die provisions of section S01(cX3) of the Internal Revenue Code of 1986. Section 501(cX4) social welfare organizations are not as restrictive because, depending upon the corporation’s articles, the assets and income of such organizations may be used for political intervention and legislative lobbying without any limitations. Section 501(cX3) charitable organizations are generally prohibited from using assets or income for legislative lobbying or other political purposes, including supporting candidates for office. It should be noted that under current law section 501 (cX3) organizations are permitted to influence legislation as long as “no substantial part of the [organization's] activities” consists o f 90 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. attempting to influence legislation.4 9 Thus, a public charity may make limited expenditures for lobbying activities. A secondary recommendation is that to make certain that die conversion proceeds will actually be used for community purposes. Congress should extend the minimum distribution rules now applicable only to “private foundations” to all section 501 (cX3) charitable organizations, die assets of which exceed a certain threshold level, say $10 million. This will force the directors or trustees of large charitable organizations to make qualifying distributions or grants out of current income unless an accumulation or “set- aside” for a special investment project can be justified. The kernel of the idea is to prevent hoarding and require the distribution of current income to the charitable corporation’s intended beneficiaries. 3.4 Who Should Manage the Proceeds? The preceding discussion explains that the sales or conversion proceeds will ultimately be held and managed by a tax-exempt charitable organization that is either a “public charity” or a “private foundation.” 5 0 Although in California all charitable corporations and charitable trusts are subject to the Attorney General’s intrinsic supervisory and enforcement powers,5 1 as a practical matter the activities of a charitable organization are entirely in the hands of the organization’s directors or trustees. The annual information reports that all charitable corporations are required to file with the Attorney General’s office contains a minimum amount of financial information and almost no information that is descriptive of the organization’s charitable purposes or annual 91 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. activities. This is not surprising, as the Attorney General has neither the human nor die monetary resources to audit these information reports.5 2 In the light of the Attorney General's scarce resources, the most likely grounds for the Attorney General's intervention in the internal affairs of a charitable organization is a complaint by a disgruntled director or trustee.5 3 In the California Supreme Court's 1964 landmark decision, Holt v . College o f Osteopathic Physicians and Surgeons, where the court allowed the minority directors of a charitable corporation to sue the majority for breach of charitable trust, the Supreme Court remarked: [T]he Attorney General may not be in a position to become aware of wrongful conduct or to be sufficiently familiar with the situation to appreciate its impact, and the various responsibilities of his office may also tend to make it burdensome for him to institute legal actions except in situations of serious public detriment (755)** The majority had argued that only the Attorney General could bring an enforcement action for breach of charitable trust but the Supreme Court wisely recognized that the problem is how “to bring to light conduct [that is] detrimental to a charitable trust so that remedial action may be taken." 5 5 The most likely persons to have knowledge of actual or possible detrimental conduct are the directors themselves. A California charitable corporation is essentially a deregulated social welfare enterprise. By permitting charitable corporations to be privately managed and operated with very little or no government oversight, the government has, in effect, “contracted-out” the management of the spending process, which is a form of privatization.5 6 To justify the "private management” of public dollars, it must be administratively prudent to avoid government program administration and allow a greater degree of spending choices than 92 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. might otherwise exist3 7 Unfortunately, “contracting-out” may or may not be efficient productive, or in die public interest The principal risk is that the directors of a charitable corporation can engage in imprudent spending or even misappropriate charitable monies (“public” trust funds). Consequently, sound public policy must consider corporate governance, including matters o f director selection and oversight 3.4.1 Corporate Governance: The Board o f Directors Under general principles of corporate law, including California law, the management of a corporation’s activities and affairs is the responsibility of the corporation’s board of directors.5 * Speaking broadly, the directors of business corporations and charitable corporations share many of the same duties and responsibilities.3 9 Thus, a corporation’s board of directors is responsible for setting or approving the corporation’s operating budget making capital investments in plant and equipment authorizing corporate distributions to stockholders (in the case of business corporations) or charitable beneficiaries (in the case of charitable corporations), establishing corporate policies and long-term goals, engaging in community networking and public relations, and selecting corporate officers to whom die day-to-day activities of die corporation can be entrusted.6 0 The salient difference, of course, is that the business corporation is supposed to serve the financial interests of its voting stockholders while die charitable corporation is supposed to serve the social welfare interests o f the non-voting members of a particular community or class of persons. In theory, the directors of a business corporation are supposed to be concerned with maximizing the wealth of die corporation’s stockholders, and the stockholders of a 93 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. business corporation are supposed to be interested in the corporation's business activities and financial affairs because of the expectation of profits from the receipt of dividends6 1 and capital gams from the sale of their shares.6 2 Consequently, stockholders are supposed to be interested in electing responsible persons to a business corporation’s board of directors,6 3 although in practice there is considerable stockholder apathy for reasons explained by the logic of collective action.6 4 Stockholders of public companies, if they are dissatisfied with corporate management, can simply sell their shares. What is important is that stockholders do have the right to vote for directors and stockholders do receive copious amounts of information for voting and investment decision-making purposes, albeit some from the corporation and, in die case of public companies, some from the business and financial press. Dissatisfied stockholders can and do initiate derivative suits against corporate management for breach o f directors’ duties and responsibilities. The directors of charitable corporations do not have stockholders or persons who have a direct financial interest in the corporation’s activities. Because the law prohibits nonprofit public benefit corporations from making distributions, their assets are required to remain in corporate solution for charitable purposes indefinitely.6 5 Since nonprofit public benefit corporations do not have financially interested stockholders who have the legal right to elect or remove directors, the law permits the directors of charitable corporations to be autonomous and self-replicating. In fact, California law permits the directors of a charitable corporation to have and exercise the power of self-selection or director perpetuation so that a director’s term of office can be unlimited.6 6 Consequently, because charitable beneficiaries do not have standing to bring an action for breach of charitable trust, 6 7 the directors of a California charitable corporation represent a government that is 94 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. essentially unaccountable to any person except, because of the decision in the Holt case, a disgruntled director who might seek to “overthrow” the corporation’s government through resource-consuming litigation. 3.4.2 The Agency Costs o f Directors The problems associated with director autonomy are similar to the typical agency conflicts that can exist between stockholders and corporate business managers.6 8 In the private sector there is no assurance that corporate business managers will always act to further the interests of the corporation’s stockholders. Because of the separation of corporate management and stockholder ownership and cost of investment monitoring, corporate managers may make risky or foolish acquisitions or other investments with stockholders’ monies instead of making dividend distributions, they make incur excessive debt and thus jeopardize the corporation’s existence, or they make pay themselves excessive salaries and other emoluments. Compensatory stock grants and options, which are designed to make corporate managers corporate “owners,” have evolved to ameliorate some of these agency conflicts. Charitable corporations represent the ultimate in separation of ownership and control because management (the corporation’s board of directors) is under no effective supervision by anyone who has a direct financial stake in the corporation’s income or assets. Indeed, the “defining characteristic” o f a charitable organization is that no person has a financial interest in the organization’s assets or earnings.6 9 True, a charitable organization exists for a class of beneficiaries, but, as previously mentioned, under California law the beneficiaries of a charitable trust do not have standing to sue; only the 95 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Attorney General, a corporate director, ora corporate officer can bring an action for breach of charitable trust7 0 So while members of the class of beneficiaries may complain that the assets of a particular charitable corporation are being mismanaged or that the charitable spending that ought to occur is not occurring, ultimately someone—or even opinion from the press—must convince the Attorney General or a corporate insider that remedial legal action is appropriate. In the light of the above, there can be no assurance that die interests of a charitable corporation's directors and die community the charitable corporation is supposed to serve will be perfectly aligned. Nonprofit corporate management can misuse cash and other charitable assets by making grants to pet causes or activities beyond the ambit of the charitable corporation's purpose and mission,7 1 by engaging in purposeless expansion for purposes of ego gratification through the acquisition (by contribution or merger) of other charitable organizations, or by making payments to themselves of excessive personal service compensation. More important, nonprofit corporate management might fail to make grants to causes or activities that would be beneficial to the community it is supposed to serve and the members of the community might lack the knowledge or the resources to remedy this failure. 3.4.3 Composition and Selection o f the Board There is nothing to suggest that positions on nonprofit boards tend to be occupied by bad or incompetent people. People do, however, serve on nonprofit public benefit boards for diverse reasons. Some may be compelled to serve by their employers who believe that "community service” is good for business,7 2 some may serve because they 96 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. have a genuine interest in the activities of the nonprofit organization, and some may serve because the nonprofit organization has rendered an important service to a family member or friend. Not everyone who serves on die board of a nonprofit corporation may take the time to study the organization or learn about die roles and responsibilities of board members.7 3 The conventional wisdom that nonprofit board members are populated by energetic people who like to engage in “policy-making, goal-evaluating” behavior may be incorrect. For example, in practice nonprofit boards [D]o not formulate policy but rather ratify policy that is presented to them by staff. . . . Some boards, especially those with strong ties among high-status members, appear to be conflict-averse and do not engage in discussions concerning controversial organizational issues, since they may disrupt the exchange relationships among members who stress the sharing of friendship, status and respect (152)7 4 Nonprofit boards populated by business people tend to be collegial and respectful of the views of other members. Consequently, controversial board issues and decisions tend to be avoided. A strong nonprofit executive staff may result in “rubber stamp” behavior by the board, not because of disinterest by board members but because most board members will want to conserve their time and energy for the many other things they have to do. So however much fun nonprofit board luncheons and presentations may be, at the end of the lunch hour homo economicus has to return to die office.7 3 Depending upon the size and resources o f a nonprofit charitable corporation, its directors may be either uncompensated lay volunteers with little management expertise or reasonably well compensated business and professional men and women.7 6 Individuals who serve as part-time directors for little or no remuneration cannot be expected to devote 97 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. substantial personal time and resources to the fulfillment of die nonprofit’s mission unless the prospect of a “public” management failure would be detrimental to their reputations within the communities in which they live and work. Some individuals will frequently agree to serve as directors or officers of tax-exempt organizations for no compensation in order to be immune from personal liability under the immunity provisions of state 7 7 and federal law.7 8 Some boards of charitable organizations may be small and dominated by a principal donor or group of donors, with the other board members being the less able “yes men” often found in corporate management7 9 “Group think” coupled with the potential evils o f nepotism and cronyism can be real and devastatingly detrimental to a charitable corporation’s purpose and mission. Although large boards (e.g., ten or more directors, none of whom is related by blood or marriage) may be problem-free, independence of thought and action is less likely to occur in the case o f small boards if some directors are related to other directors. Director independence is important because an independent director is likely to be more willing to challenge other directors and engage in effective monitoring activity than a “dependent director” (i.e., a director who has family cr business ties to other members of the board). Remember that in the Holt case, it was the minority directors who accused the majority of a breach of charitable trust; it is highly unlikely that the minority would have complained to the Attorney General if the board had been ripe with “yes men,” nepotism, or cronyism. Under California law, business corporations are required to have a minimum of three directors but nonprofit public benefit or charitable corporations may have a minimum of one.8 0 The minimum requirement of a single director is true regardless of the amount of 98 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the charitable corporation's assets or income. Thus, there is no requirement that larger charitable corporations have more directors than smaller charitable corporations. There are no statutory qualifications for serving as a director of a charitable corporation, and there is nothing in the law that would prevent nepotism or cronyism from occurring. Fortunately, there is a statutory solution. Under California law, nonprofit public benefit corporations are permitted to have “members”—persons who, under the corporation's articles of incorporation or bylaws, are permitted to exercise significant corporate governance rights. In particular, the “members” of a nonprofit public benefit corporation may exercise the following rights: the right to vote for the election of the corporation's directors, the right to vote if the corporation is to be merged or dissolved, the right to vote if the corporation’s assets are to be sold, the right to amend the corporation’s articles or bylaws, the right to remove a director from office with or without cause, and the right to initiate a derivative suit to remedy a breach of charitable trust.*1 In a nutshell, except for the inability to receive distributions from the charitable or public benefit corporation,*2 for corporate governance purposes “members'' are the functional equivalent of voting stockholders. A nonprofit public benefit corporation may issue “membership’ ’ interests for “no consideration’ ’ or for “such consideration as is determined by die board.” 8 3 Thus, prospective donors may condition their gifts to a charitable or nonprofit public benefit corporation on their becoming “members” so that they will be able to influence the corporation’s mission and its charitable activities through their right to elect and remove directors, vote on important corporate matters, and threaten to bring or actually bring an action to enjoin or correct a breach of a charitable trust by the corporation’s directors or 99 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. officers. A nonprofit public benefit corporation’s articles or bylaws can even provide for the transferability of an individual membership upon a member’s death so that an interested family can retain some degree of future control over the charitable corporation’s policies and activities.*4 For corporate governance purposes, the important concept is that a charitable corporation’s articles or bylaws may permit “members” to be selected or appointed by any person or group of people. Thus, an elected public official (e.g., the Attorney General, a county board of supervisors, a city council, the mayor of a city), the head of a nonprofit consumer advocacy group, or a recognized community leader could be given the right to appoint one or more individuals to serve as “members” of a charitable corporation for a specified period of time. Even the residents of the community that is served by the charitable corporation could be given the right to elect “members” just as they would have the right to elect community college trustees. The elected members would be expected to perform oversight activities and represent the interests of the corporation’s charitable beneficiaries. Unfortunately, according to the Attorney General, few nonprofit public benefit corporations have “members” because membership interests are pregnant with powerful governance rights that directors want to avoid. Surprisingly, California’s leading legal treatise on nonprofit corporations takes the view that “members” should be avoided because they have enforceable rights and too many members with disparate views and enforceable rights may unnecessarily “politicize” the organization and frustrate its purpose.8 3 There are also the concomitant dangers of “member” groupthink, nepotism, and cronyism. Thus, whether the presence of “members” will unnecessarily politicize a 100 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. nonprofit corporation or stimulate healthy debate and disagreement that will reduce the opportunity for the mismanagement of charitable assets remains an empirical question. In lieu of “members,’ ' almost all California nonprofit public benefit corporations have directors who can nominate and select their successors with impunity and the absence of any oversight from the Attorney General.8 6 3.4.4 Policy Recommendations Since the charitable corporations that are created or funded through hospital conversions will have private management, the most important task is the selection and composition of the corporation’s board of directors. California’s present law does not recognize the public’s stake in nonprofit public benefit corporate management because it allows the board to self-replicate. There is no assurance that the board of a California charitable corporation is or will be competent to undertake its management mission and serve the public interest effectively. More important, because o f the Attorney General’s resource limitations, there is effectively no public oversight The first recommendation is that to reduce nepotism, cronyism, and foster independent thinking, the board must be composed of individuals who are unrelated to each other by blood, marriage, or employment Individuals who served on die board of the selling nonprofit hospital should not automatically be excluded from board membership, but neither should the board of the charitable organization be overwhelmed with the selling hospital’s former board members. A high degree of professionalism and education should be required for board membership, and every effort should be made to attract board candidates who both reside within, and are representative of, the community the 101 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. organization will serve. Since the board as a whole will have to know something about health care, financial management, and philanthropy, consideration should be given to using one or more executive search or consulting firms to help find, attract, and screen suitable candidates who possess the requisite skills for board membership. The second recommendation is that, depending upon the amount of the organization’s assets, the board should have at least seven directors but not more than fifteen directors. If the board is too small, the board’s thinking may be discrete, insular, and unrepresentative of the community’s interests, but if the board is too large, there may be problems with shirking, attendance, and achieving consensus. Ideally, an odd number of directors is desirable because it tends to eliminate conflicted decisions. Board members should serve for at least four years, which is long enough to accomplish something that is meaningful. However, to promote independence of thought and action and prevent corruption in office, no board member should be permitted to serve more than two terms. The third recommendation is that charitable organizations created by or funded with proceeds from hospital conversions have two or more “members’ * within the meaning of California’s Nonprofit Public Benefit Corporation Law.1 7 A board with seven directors should have at least two members, and a board with fifteen directors should have at least three members. In no case should the total number of members exceed five. Since California law gives nonprofit public benefit corporations considerable flexibility in determining who may be a “member,’ * ® * persons could be admitted to membership for a limited term of office (say three years, with a service limit of two terms) on the basis of executive or judicial appointment, or even a special community election. Although the board of directors could be given the power to appoint “members,” this is inadvisable 102 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. because there is no assurance that a board would always appoint “independent” persons to the position. Chapter 4 contains a section on public members and their possible selection. The fourth recommendation is that California law should not permit section 501(cX3) charitable organizations to be governed by executive committees without appropriate expenditure restrictions. Under California law, nonprofit public benefit corporations may establish an “executive committee” that, with limited exceptions, is vested with plenary power and thus “all the authority of the board.”8 9 Such committees are useful in the case of nonprofit organizations with especially large boards, since rarely, if ever, is it feasible for the members of an extremely large board to congregate for a meeting. Unfortunately, if an “executive committee” exists, less than the full complement of the organization’s board of directors (or even a quorum) can make significant expenditure decisions without the advice and consent o f the other board members. A restriction is appropriate to assure due and adequate deliberation by the entire board, or at least a quorum of the board for the transaction of corporate business (i.e., generally, a majority of the number of directors authorized in the articles of incorporation or bylaws9 0 ), of all charitable expenditure decisions. Finally, California law permits nonprofit public benefit corporations to have one or more advisory committees to aid the board of directors in managing die corporation’s charitable activities and affairs.9 1 The members of advisory committees may be community volunteers; they need not be voting directors. Thus, a charitable corporation could establish an advisory committee and staff it with community volunteers to help the board implement and oversee die corporation's charitable programs. In the case of charitable corporations created by or funded with proceeds from hospital conversions, the 103 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. mandatory use of an advisory committee for charitable program or grant determination purposes would assure community participation and thus a strong measure of community' based planning. 3.5 How Should the Conversion or Sales Proceeds Be Used? Speaking generally, how charitable assets are required to be used depends upon a charitable organization’s articles of incorporation or trust agreement, and the interpretations that can be given to the operant language in those governing instruments. The charitable organization’s directors or trustees are primarily responsible for interpreting the governing instruments and canying out the organization’s charitable purposes and mission. A lawsuit to remedy a breach of charitable purpose or trust may be brought by an officer or a director of the charitable corporation (as in die Holt case), or, in egregious circumstances, by the Attorney General.9 2 The beneficiaries of a charitable corporation or trust do not have standing to bring an action to enjoin, correct, or otherwise remedy a breach of charitable trust9 3 In the case of hospital conversions, the cessation of hospital activities due to the hospital’s sale means that the sales proceeds will have to put to a new and different charitable use. The common law of charitable corporations and trusts permits a court of competent jurisdiction to allow assets held in charitable trust to be devoted to a new and different charitable purpose where circumstances have made it impossible or impractical for the charitable organization’s directors or trustees to carry out the organization’s historic charitable purposes. It is against this backdrop that some consumer groups, including 104 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Consumers Union, the publisher of Consumer Reports, and the Volunteer Trustees Foundation for Research and Education, have expressed their concerns about die use to which the hospital sales and other conversion proceeds are being put9 4 3.5.1 Permissive Charitable Purposes Under California law, a nonprofit public benefit corporation may be formed for “public or charitable purposes.” 9 5 There is, however, no statutory definition of “public” or “charitable” purpose. The Internal Revenue Service and most American courts look to die Statute of Charitable Uses, which Parliament enacted in 1601 shortly before the death of Elizabeth I. The preamble to that famous statute states that charitable purposes include relief of poverty, advancement of education and religion, promotion of health, maintenance of the sick, and aid to government9 6 Although some courts continue to hold that the preamble to the Statute of Charitable Uses continues to govern the definition of “public or charitable purposes,” 9 7 in general a public or charitable purpose connotes something that will be of benefit to a sufficiently large class of persons within a specified community and that will not be otherwise illegal or detrimental to die community.9 6 In modem practice, the articles of incorporation or trust agreement determine the uses to which the public or charitable funds may be put Thus, those who contribute money or other property to a charitable cause are deemed to have impliedly sanctioned a specific use that cannot be changed or otherwise thwarted by die charity’s management As a result of the California Supreme Court’s 1964 decision in Holt v. College o f Osteopathic Physicians 9 9 and the Court of Appeal’s 1977 decision in Queen o f Angels 105 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hospital,1 0 0 the governing or creating documents of a charitable trust or nonprofit public benefit corporation are required to be strictly construed. In H olt, the Supreme Court refused to permit a nonprofit corporation devoted to osteopathic medical education to become an allopathic school of medicine even though the California Attorney General, who is a necessary party to any litigation involving a charitable trust or a nonprofit public benefit corporation, supported die change of use as being in the “public interest” The corporation’s articles of incorporation narrowly restricted its activities to providing osteopathic medical education and the court saw no need to deviate from that express purpose and thus thwart the wishes of the school’s founders or successor donors. Similarly, in Queen o f Angels, die Court of Appeal, following the decision in Holt, refused to allow Queen of Angels to establish “free” medical clinics in east and south central Los Angeles because the corporation’s articles of incorporation did not literally permit any clinics to be established. This time the Attorney General contended that under its articles o f incorporation. Queen o f Angels was required to use its assets solely for the purpose of operating a hospital, not for die purpose of establishing and maintaining outpatient clinics. Although the clinics would have served the “public interest" and the hospital had sufficient resources to establish the clinics, there was no legal mandate to do so. In the light of the Holt and Queen o f Angels decisions, it is not “general charitable purposes” but “specific charitable purposes” that count It is not the “public interest” that is to be served by charitable trusts and charitable corporations but the “interests” of one or more specific classes of identifiable beneficiaries. The “public interest” or the “public 106 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. welfare” is too vague to be o f any concrete value. When charitable entities are organized, the governing documents (either the articles of incorporation or die declaration of trust) generally contain specific purposes. The language in the governing instrument is to be read literally and the legal construction is to be as narrow as possible. In Holt, the articles of incorporation referred to osteopathic medicine, not allopathic medicine, and the Supreme Court was reluctant to expand the corporation’s educational mission because it recognized that osteopathic medicine and allopathic medicine do not share die same philosophical underpinnings. It did not matter to the Court that the school's resources would be used to further “medicine” because of die important qualifier, “osteopathic.” Similarly, in Queen o f Angels the court recognized that the corporation’s stated purpose, which was “to establish, . . . own, . . . maintain, . . . and operate a hospital in the City of Los Angeles,. . . and do all things necessary or advisable in conducting and carrying on a hospital,” 1 0 1 did not permit the use of hospital resources for medical clinics. The Court ignored other language in the hospital’s articles of incorporation that referred to “acts of Christian charity particularly among die sick and ailing.” Certainly this language would have supported die establishment of clinics had die Court been so inclined to rule. In neither the Holt nor Queen o f Angels cases was there a failure of purpose due to financial distress. Thus, there was no reason for the court to allow die organizations’ assets to be used for similar “public benefit” or charitable purposes. In the case of hospital conversions, however, there is usually a failure of purpose; i.e., for financial reasons it is impossible or impracticable to continue normal hospital activities so that the sale of the 107 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospital facility to a “for profit” corporation is necessary in order to avoid insolvency or bankruptcy and the concomitant less o f hospital services to die community.1 0 2 In cases of impossibility or impracticality, a court can use its judicial power (known as the common law doctrine o f cy pres1 0 3 ) to apply assets held in charitable trust to a new and different charitable purpose. For example, in 1965 the United States Court of Appeals for the Fourth Circuit, in Smith v . Moore,1 0 * applied Virginia’s doctrine of “equitable approximation” (similar in result to cy pres) to divert charitable funds to a clinic of an existing charitable hospital instead of a new charitable hospital because the fund was too small to support the construction o f a new hospital facility. It was clear to the Court that the testator had intended die funds to be used for charitable hospital purposes within a specific community. Since a new public hospital could not be built, the sensible result was to allow the gift to be used by the existing nonprofit (charitable) hospital. The judicial doctrine of cy pres is subject to a number of judicial qualifications and thus it is limited. In neither Holt nor Queen o f Angels was there any showing o f financial distress or financial necessity; i.e., the osteopathic school of medicine had sufficient student applicants, and there was no need for Queen of Angels to devote its financial resources to the establishment of “free” clinics in die poorer parts of Los Angeles. Consequently, unlike the decision in Smith v . Moore, there was no need for either California court to consider judicial modification of the underlying charitable trusts. But where modification is required, as in the case of a hospital conversion, in framing a scheme for the use of the sales or conversion proceeds by the successor charitable organization the court will attempt to follow the nonprofit hospital’s historic charitable purposes. Unfortunately, the problem with this approach is that if die hospital was not economically 108 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. viable, the hospital's historic spending patterns may be a poor guide to the community’s present and future actual healthcare needs. 3.5.2 Establishing Use Standards How charitable organizations funded or created by the proceeds of nonprofit hospital sales or conversions should use their charitable wealth depends upon state law considerations. Under the Holt and Queen o f Angels decisions, in the event of a failure of charitable purpose (i.e., the hospital is sold and thus the hospital assets are monetized), a new but similar purpose is to be constructed by the courts. California’s hospital conversion law, which is effective for hospital conversions occurring on and after January 1, 1997, requires that the proposed use of die conversion proceeds be “consistent with the charitable trust” that governed the activities of the selling nonprofit hospital facility.1 0 5 According to the California Attorney General’s hospital conversion review protocol and regulations,1 0 6 [T]he remaining (or successor) charity must utilize the assets for a like charitable purpose benefiting die same class of beneficiaries. (Citations omitted.) Obviously any newly-created charity must have the same purposes and same dedication clause as its predecessor. In those instances where a sale of assets results in the reallocation of funds from an operational use to a grant-making use, it is particularly important to insure that a constancy of purpose is maintained. Where specific charitable purposes are likely to be lost or significandy diminished by the sale of assets, restrictions should be placed on the sales proceeds to mitigate those losses and to insure that those charitable purposes continue. In almost all such cases, a court-validating procedure will be required because a modification o f [charitable] trust purposes is involved. 109 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The above language merely reflects the decisions in die Holt and Queen o f Angels cases so that there is nothing that is new. The problem, however, is still threefold: first, die Attorney General must set standards for the use of hospital conversion proceeds to which a court must give its consent; second, those standards, once established, must be implemented by the charitable organization's management; and third, the Attorney General must be able to monitor compliance with those standards. Unfortunately, the concept of a “like charitable purpose benefiting the same class of beneficiaries" is operationally vague. The language in die Attorney General’s review protocol and regulations is sufficiently elastic to embrace a wide range of health care related charitable activities. In the two hospital conversions that were approved after the effective date of California’s hospital conversion law (January 1, 1977), Tenet Healthcare’s acquisition of Queen of Angels—Hollywood Presbyterian Medical Center and Columbia/HCA Healthcare Corporation’s acquisition of Riverside Community Hospital, the Attorney General sanctioned a broad range of health care related activities. In both instances, the Attorney General retained the services of outside health care consulting firms for program development and evaluation purposes. The technical appendix to this chapter contains information about die six hospital conversions shown in Table 10. The Queen of Angels and Riverside Hospital conversions are particularly instructive because, having been approved after 1996, their public files contained die best documentation. 110 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.5.2.1 Queen of Angels— Hollywood Presbyterian Medical C enter The articles of incorporation of Queen of Angels—Hollywood Presbyterian Medical Center were drafted in 1936 and modified in 19S9. As originally drafted, the nonprofit corporation’s purpose was to “acquire” and “maintain and/or operate” a hospital, sanitarium, or infirmary. As amended in 1959, die nonprofit corporation’s purpose was to conduct and operate “hospitals,” “clinics,” and other facilities for the “care and treatment” of the “sick, afflicted and aged,” and to carry on “any other lawful business” that may be carried on by a nonprofit corporation. In die light of this language, it is reasonably clear that since 1959 the nonprofit corporation could legally provide a wide range of services for the “care and treatment” of the “sick, afflicted and aged.” To comply with California’s hospital conversion law and the requirements of his own protocol, the Attorney General retained the services of the Lewin Group,1 0 7 a healthcare policy research and management consulting firm, to ascertain the hospital’s historic pattern of charitable healthcare expenditures. As a result of the Lewin Group’s analysis, the Attorney General determined that QueensCare, the successor charitable organization that would be funded with $278 million as the result of Tenet Healthcare’s 1998 purchase of Queen of Angels—Hollywood Presbyterian Medical Center, should use the conversion proceeds in the following manner 1 0 8 • Permanently set aside $160 million, substantially all of the income from which is to be used to provide charitable care for the medically indigent residents of the greater Hollywood area (i.e., the historic zip 111 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. code areas served by die Queen of Angels—Hollywood Presbyterian Medical Center); • Permanently set aside $49 million, the income from which is to be used to subsidize or provide bilingual, transportation, AIDS, and other services to residents of the historic zip code areas served by Queen of Angels; • Permanently set aside $37 million, the income from which is to be used to fund community clinics, pastoral care, education, and other programs; • Permanently set aside $32 million, the income from which is to be used to fund discretionary health care grants. In 1998, the articles of incorporation of QueensCare were restated to reflect judicial and administrative approval of the Attorney General’s plan. The restated articles actually contain thirteen sub-funds that govern die legal ability o f QueensCare’s directors to make charitable grants, and additional details are contained in Appendix C, the technical appendix to this chapter. Although the Attorney General was satisfied that the sub-funds would protect the community’s health care interests, Consumers Union wanted further modifications and it complained, publicly, when the Attorney General summarily rejected its spending concerns without a meeting.1 0 9 112 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The Attorney General's press releases do not tell the entire story. Of the $278 million figure that would be available to QueensCare, approximately $132 million would be derived from the sale to Tenet and the balance (approximately $146 million) would represent previously accumulated charitable assets (principally cash and securities). The Attorney General’s spending guidelines embrace not only the sales proceeds but also previously accumulated charitable monies. The inclusion of the hospital’s previously accumulated monies within the ambit of the Attorney General’s spending plan would seem to be questionable because the Attorney General’s hospital conversion review protocol and regulations appear to require any previously accumulated monies to be used for their restricted purposes.1 1 0 3.5.2.2 R iverside Community Hospital The other example is the 1997 acquisition of Riverside Community Hospital by Columbia/HCA Healthcare Corporation, the first transaction completed under California’s new hospital conversion statute.1 1 1 Although the hospital was organized in 1901, die relevant articles of incorporation, which date from 198S, permit the nonprofit corporation to “own, operate and manage a health care system, consisting of charitable hospitals and related health programs.” The Attorney General retained the services of the Camden Group, a health care consulting organization,1 1 2 to assess the community’s healthcare needs and make recommendations regarding the use of the conversion proceeds. After reviewing the hospital’s historic mission, community benefit plan, and relevant financial and demographic information, the Camden Group recommended to the 113 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Attorney General that the cash proceeds of approximately $28 million should be used in the following manner • Approximately 55 percent of the income from the conversion proceeds is to be used to compensate other hospitals and healthcare providers for the cost of rendering in-patient healthcare services to indigent residents of Riverside County; • Approximately 42.5 percent of the income from the conversion proceeds is to be used to fund indigent resident outpatient care; • The remaining 2.5 percent o f the income from the conversion proceeds is to be used to support health and medical education in Riverside County. The judicially and administratively approved 1999 restated articles of incorporation of Community Health Corporation, Riverside’s corporate parent and the successor charitable corporation, reflect the above historical proportions of indigent or charitable hospital services. An interesting question is why Community Health Corporation’s restated articles are not as complex as QueensCare’s restated articles. The answer may be that in Riverside’s case, the Camden Group found Riverside Hospital's charity patients to be overwhelmingly (at least 84 percent) low-income white and Hispanic community residents with substantially similar health care needs. In QueensCare’s case, I suspect the Lewin Group encountered many more special interest groups seeking funding for special needs. 114 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.5.2.3 Normative Considerations The heart o f the public policy debate seems to be the construction that is to be accorded the phrase, “for a like charitable purpose benefiting the same class of beneficiaries.” 1 1 3 For example, the use standards approved for the sales proceeds of the Queen of Angels and Riverside Community hospitals would appear to be broad and yet the legal precision (the language in the governing documents) is complex. Although in both cases more than fifty percent of the conversions proceeds are to be used for indigent care, this may be insufficient One must recognize that, as a matter o f law, donors contributed monies to nonprofit community hospitals to improve public health. Furthermore, at least in the beginning, nonprofit hospitals were granted tax-exempt status based upon a charitable standard that focused on the amount of uncompensated hospital care they would be providing to indigent persons within the communities in which they were constructed and operated.1 1 4 Not until 19S6, however, did the Internal Revenue Service establish a specific standard for hospital tax exemption. In that year, in Revenue Ruling 56-185,'1 5 the Internal Revenue Service publicly ruled for the first time that to be tax-exempt under the provisions of section 501(cX3) o f the Internal Revenue Code of 1954,1 ,6 a hospital must [B]e operated to the extent o f its financial ability for those not able to pay for the services rendered and not exclusively for those who are able and expected to pay. . . . It must not . . . refuse to accept patients in need of hospital care who cannot pay for [hospital] services. 115 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This language indicates that die origin of die community nonprofit hospital's tax exemption is the provision of uncompensated care to indigent patients. It is very likely that a hospital’s decision to provide care to indigent patient also attracted donor gifts. In subsequently published rulings, die Internal Revenue Service substantially eroded its earlier indigent patient care standard. Thus, in Revenue Ruling 69-545,1 1 7 the Internal Revenue Service permitted a hospital to be tax-exempt [E]ven though the class of beneficiaries eligible to receive a direct benefit from its activities does not include all members of the community, such as indigent members of die community, provided that the class is not so small that its relief is not of benefit to the community. Under the new standard for obtaining tax-exempt status, a hospital need only provide a “benefit” to a reasonably large class of persons within the “community.” The ruling makes it clear that a hospital may fail to serve indigent members of a community and yet retain its tax-exempt status. The “indigent patient care” origin of the nonprofit hospital’s donor support and claim for tax-exempt status is important because it strongly suggests that nonprofit hospital sales or conversion proceeds should be returned to the community in the form of health care dollars. This means that charitable organizations created by or funded with proceeds from nonprofit hospital sales or conversions should adopt uncompensated patient care as their primary mission and thus make health care funding available to indigent patients, the uninsured, and the uninsurable. In this manner, die public will be effectively compensated for the subsidies (through tax expenditures) given to the nonprofit community hospitals."8 116 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The narrow “indigent patient care” standard, however, is at odds with the California Legislature’s findings that private or nongovernmental “not-for-profit’ ' hospitals provide a wide range of community benefits, including die following:"9 1. Community-oriented wellness and health promotion programs; 2. Disease prevention services; 3. Adult day care; 4. Child care; 5. Medical research; 6. Medical education; 7. Professional training for nurses and physicians; 8. Home-delivered meals to the homebound; 9. Free food, shelter, and clothing to the homeless; and 10. Outreach clinics in socioeconomically depressed areas. In the light of these articulated “community benefits,” it is thought that the Attorney General and the courts should be able to take a more inclusive approach in establishing spending standards for conversion proceeds. Presumably, this could be done through an examination of the converted nonprofit hospital’s annual community benefit plan, which is required by law to be filed with California’s Office of Statewide Health Planning and Development1 2 0 Because of the decisions in the Holt and Queen o f Angels cases, the Attorney General has been somewhat reluctant to embrace the “community benefit” standard. In January 1996, the Attorney General approved the sale of the Good Samaritan Health 117 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. System in Santa Clara County to Cohnnbia/HCA but he did not approve how the resultant charitable organization (the Good Samaritan Charitable Trust, a California nonprofit public benefit corporation) would use die net sales proceeds of almost $72 million.1 2 1 In April 1997, the Attorney General announced that the proceeds would be used “to continue charitable activities previously provided by Good Samaritan to the community.” Accordingly, • $6.9 million will be used to fund unspecified (discretionary) community benefit programs; • $10.3 million will be used to fund certain school health centers that provide primary health care services to public school children in Santa Clara County; • $54.6 million will be placed in trust to be used only to provide hospital (approximately $34 million) and outpatient (approximately $20.6 million) medical care to medically indigent residents of Santa Clara County. Additional information is contained in the technical appendix to this chapter. Almost immediately thereafter, die dissatisfied directors of the Good Samaritan Charitable Trust (now The Health Trust) asked California State Senator Kenneth L. Maddy to sponsor legislation that would permit hospital conversion proceeds to be used for any “community benefit” purpose as the term “community benefit” is defined by law, 1 2 2 including providing health care services to the uninsured and underinsured, reimbursing 118 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the community for the cost of providing health prevention and adult day care and child care services to community residents, and providing “goods or services that help maintain a person’s health” 1 2 3 such as food, shelter, clothing, education, and transportation. Senator Maddy’s views would seem to be consistent with the previous findings of the California Legislature. The Senator’s position is that [I]t is time to allow nonprofit hospitals to dispose of their assets to provide for a variety of community benefits such as wellness programs, prevention services, medical research and other important community health programs.. . . [EJxisting case law is too confining, forcing nonprofit hospitals to use their sale proceeds only for related hospital services, even when such services are no longer essential to the health of a community.1 2 4 The proponents of Senator Maddy’s measure also included Pacific Hospital of Long Beach and Riverside Community Hospital, each of which considered the Attorney General’s expenditure guidelines to be too restrictive. Unfortunately, the bill died in the California Assembly 1998, which was also Senator Maddy’s last year in the California Senate.1 2 5 The bill was opposed by the Attorney General, who contended that charitable corporations should not be permitted to use their assets for a broad array of health programs that might be inconsistent with their articles of incorporation, and by Consumers Union, which thought hospital conversion proceeds should be primarily dedicated to preserving hospital services and related charitable care. Other groups complained that the bill would “violate the intention of donors” who thought they had donated monies specifically to support charitable hospital 119 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The problem with the objections to Senator Maddy’s proposal is that the Attorney General's spending agreements with the foundations created by die conversions of Riverside Community Hospital, Queen of Angels—Hollywood Presbyterian Medical Center, and Good Samaritan Health System go well beyond the provision of hospital services to the medically indigent The new foundations are, in fact broad-based “social welfare” organizations rather than traditional “charitable” organizations dedicated to die provision of hospital care in-patient services.1 2 7 As long as there is a community benefit that is proximately related to health care, the actual spending decisions of the newly established foundations should remain in the hands of the their respective board members. However much the Attorney General disdained Senator Maddy’s proposal, in practice the Attorney General has expressly sanctioned what Senator Maddy wanted to legalize. The alternative to the “community benefit” approach would appear to be the more narrow “indigent patient care” spending standard. At this time, it appears that the more narrow “indigent patient care” spending standard could remain in place. Last year, the California Legislature enacted a law that requires the Attorney General to evaluate whether or not the legislature should establish additional standards for charitable hospital care.1 2 8 According to its legislative history, some legislators believe (along with Consumers Union and the California Nurses Association) that the charitable care policies of nonprofit tax-exempt hospitals are not meeting community hospital needs.1 2 9 In particular, some legislators are now concerned that tax exemptions and other state subsidies available to nonprofit hospitals are costing the state too much money in relation to the amount of charitable care that is being dispensed to indigent patients.1 3 0 More than fifteen years ago the Supreme Court of Utah ruled that 120 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. because there may be little or no difference between a “for-profit” hospital and a “nonprofit” hospital, a nonprofit hospital's entitlement to state tax exemptions should be decided on a case-by-case basis after taking into account die amount of the hospital’s expenditures for charitable care.1 3 1 A number of states, including California, are now questioning charitable tax exemptions for nonprofit hospitals.1 3 2 3.5.3 Implementation and Compliance Once the successor organization's charitable “use” standards have been established by the Attorney General and approved by the judiciary, there remains the question of how to implement those standards and monitor compliance. The relevant framework to understand implementation and compliance problems is delegation and agency. Briefly, the Attorney General (with judicial approval) has a policy agenda that states how the successor organization must use the hospital conversion proceeds. The problem is that this policy agenda can be at odds with the preferences of the directors and officers of the charitable organization who are responsible for interpreting and implementing the Attorney General’s policies. Although some policy slippage is to be anticipated and expected during the course of implementation,1 3 3 the kernel of the problem is how to minimize die agency or welfare loss that can result from the inappropriate behavior of private individuals to whom certain public spending decisions have been delegated.1 3 4 Monitoring and self-reporting requirements are traditional in both the government and private sectors. The fundamental problem, which is well known to income tax administrators, is one of truthful revelation: can the reporting party be trusted to reveal that which may be economically or legally detrimental to his self-interest? In the case of 121 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. charitable organizations, the existence of random management audits conducted by the Attorney General coupled with the imposition of severe sanctions or penalties for untrustwoithiness (breach of fiduciary duty) is certainly one possibility. The problem is that such audits are time consuming and expensive, and the Attorney General does not have the human or financial resources to undertake this task.1 3 2 Under current law, a charitable organization must file an annual report with the Attorney General (actually, the Registrar of Charitable Trusts, which is part of the Attorney General’s office) disclosing the amount of the organization’s gross receipts, total assets (including marketable securities), and amounts paid to employees and commercial fundraisers. Although the current reporting form (Form CT-2) does not require a charitable organization to provide significant or substantial information about its gross receipts, administrative expenses, or charitable expenditures, it does require either Internal Revenue Service Form 990 (“Return of Organization Exempt from Income Tax”) or Internal Revenue Service Form 990-PF (“Return of Private Foundation”) as an attachment Unfortunately, there is no requirement that a charitable organization submit complete and proper financial statements, prepared in accordance with generally accepted accounting principles applicable to nonprofit organizations,1 3 6 to the Registrar o f Charitable Trusts. The lack of resources to audit and investigate misfeasance or malfeasance by a charitable organization’s directors and officers may explain the paucity of the Attorney General’s charitable audits.1 3 7 To eliminate the drawbacks associated with self-reporting and the Attorney General’s resource constraints, the new hospital conversion statute allows the Attorney General to hire outside experts and consultants to assist in policy implementation and 122 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. compliance.1 3 8 Under the statute, the cost o f hiring any experts and consultants is required to be borne by the selling nonprofit hospital for a period of time to be contractually agreed upon by the hospital and the Attorney General.1 3 9 Following the expiration of this time period, however, the Attorney General's office must bear the expense of any compliance audits. If the Attorney General chooses to make extensive use of his authority to retain outside experts and consultants to assist in implementation and conduct independent compliance audits, welfare losses due to inappropriate behavior by the management of a charitable organization should be minimized. However, once the contractually agreed upon time period is up, the Attorney General’s office will have to revert to the current policy of monitoring and self-reporting. An efficient alternative to monitoring and self-reporting is to require a charitable organization to be accountable to its potential beneficiaries. Because potential beneficiaries have an economic incentive to study and observe the activities of charitable organizations and to complain, publicly, to an organization’s directors and officers (and ultimately to the Attorney General) in the event of perceived misconduct, they are likely to be ideal monitors. First, beneficiary complaints will require a charitable organization’s directors and officers to publicly explicate the organization’s goals and strategies in an effort to resolve those complaints. Second, beneficiary influence is likely to be especially great if the charitable organization has “members” who are publicly elected or appointed. Consequently, public disclosure of financial and operating information would seem to be the optimal method for assuring that charitable organizations will use their resources consistent with the charitable trusts on which their assets are held. 123 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The notion that public scrutiny of an organization’s financial statements will help bring to light possible misfeasance or malfeasance by a charitable organization’s directors or officers is relatively new. In 1987, Congress first mandated that a tax-exempt charitable organization make a copy of its annual information return (Internal Revenue Service Form 990, showing the organization’s income, expenses, assets, and liabilities) available for public inspection at the organization’s principal place of business.1 4 0 The problem, however, is that a donor or other interested person (i.e., an investigator, researcher, or possibly a beneficiary claimant) who wanted to examine the organization’s Form 990 was forced to visit the organization’s principal office. In 1996, Congress amended the law to provide that “a copy” of the annual return “shall be provided to such individual without charge other than a reasonable fee” to cover reproduction and mailing costs.1 4 1 Thus, a person who wants to examine a charitable corporation’s Form 990 need no longer journey to the corporation’s principal office to inspect the form. Regulations recently promulgated by the Department of the Treasury encourage nonprofit organizations to post their Forms 990 on the Internet for public viewing and downloading,1 4 2 and recently the California Attorney General has posted the “Charities Data Base” on his website (w w w raaq ctat* cat The Attorney General’s data base contains the names of California registered charities and their most recently filed financial reports, including Internal Revenue Service Forms 990.1 4 3 There is a logical extension to what Congress and the California Attorney General have done. Neither Form 990 nor Form CT-2 requires financial statements (the balance sheet, income statement, and cash flow statement, whether audited or unaudited), together with any required footnote disclosures, to be submitted as an attachment This information 124 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. should be made public because Forms 990 and CT-2 do not necessarily require the same information and hence the government forms are not the equivalent o f financial statements. More important, relevant qualitative information about the charitable organization’s performance and the stewardship or accountability of its managers needs to be disclosed. According to the Financial Accounting Standards Board, the public should know whether or not, as well as how, a charitable organization has complied with its spending mandates, and the public should also know something about a charitable organization’s service efforts and accomplishments.1 4 4 Thus, in addition to financial statements, the FASB would have a nonprofit organization provide substantial qualitative information about organization performance, including managers’ explanations of material transactions, events, and circumstances. This kind of information is already required to be supplied by public companies to the Securities & Exchange Commission, and there is no reason not to require large charitable organizations, say those with assets or gross receipts in excess of S10 million, to make similar filings for disclosure purposes.1 4 3 3.5.4 Policy Recommendations The proper use of charitable assets is fraught with emotion and controversy because there are conflicting preferences among government officials and regulators, private sector managers, and the public, including donors and potential beneficiaries. No program o f expenditures will please everyone, and some management decisions may be publicly unpopular. Nevertheless, the following recommendations would seem to be warranted and prudent 125 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. First, in the case of hospital conversions proceeds, it may be good public policy to require the successor charitable organization to accord preferential expenditure treatment to the medically indigent, die underinsured, and the uninsurable. This policy of focusing on uncompensated medical care will effectively reimburse the government for years of tax expenditures and it will reduce the necessity for government to raise taxes to provide health care services for die indigent The Attorney General’s anticipated report about whether or not the legislature should mandate specific charitable care standards for nonprofit hospitals as a condition to the retention of their tax-exempt status is expected to address this issue in depth.1 4 6 A policy of focusing on the medically indigent should also reduce the opportunity for inappropriate spending and thus minimize the need for monitoring and compliance activities. The provision of medical (hospital) care to those without sufficient means is the very essence of the charitable hospital care that was envisioned by the Internal Revenue Service when tax-exempt status for hospitals became publicly available in 19S6. The California Attorney General’s charitable use standards for the hospital conversion proceeds from Queen of Angels—Hollywood Presbyterian Medical Center, Riverside Community Hospital, and the Good Samaritan Health System are consistent with this recommendation because of the substantial amounts their respective conversion foundations are required to devote to indigent in-patient hospital care (Queen of Angels, at least 58 percent; Riverside, at least 55 percent; and Good Samaritan, at least 47 percent). Second, conversion proceeds in excess of an amount required to provide uncompensated medical care should be made available for a wide range of “community benefit” programs. To promote sound expenditures by die charitable organization’s 126 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. managers, every charitable conversion organization should have a program expenditure committee that is comprised of directors and community volunteers. The purpose of having volunteers assist in the program expenditure process is to ensure community awareness and a significant level of community advocacy or public involvement Finally, charitable organizations should be made publicly accountable to regulators, donors, and potential beneficiaries. Accountability can be substantially improved by requiring charitable organizations to prepare annual financial statements in accordance with generally accepted accounting principles applicable to nonprofit organizations. As part of the annual reporting process, and as recommended by the Financial Accounting Standards Board, the organization’s managers (directors and officers) would be required to qualitatively explain the organization’s activities for the previous year and disclose the organization’s proposed activities and expenditure budget for the forthcoming year. 3.6 Summary and Conclusions According to the California Attorney General’s public charities database, California’s charitable assets amount to more than $200 billion.1 4 7 Since nonprofit schools, nonprofit hospitals, and religious groups are not required to report their assets, receipts, or expenditures to the California Attorney General, this $200 billion figure is understated. This reporting gap notwithstanding, it is clear that nonprofit public benefit corporations (principally “public charities” and “private foundations”) are responsible for managing an enormous amount of charitable assets. What is even more remarkable is that the charitable 127 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. assets of these corporations, which the Registry of Charitable Trusts, die Internal Revenue Service, and the Franchise Tax Board may from time to time monitor, are under the dominion and control of ordinary people who may not have had any special training in the administration or management o f philanthropic assets. In California, between 1993 and 1998 there were eleven sales of nonprofit hospitals to “for-profit” hospital organizations, the aggregate consideration of which amounted to less than SI billion—less than 1 percent of California’s total charitable assets.1 4 8 These “conversion” transactions have received an amount of publicity, legislation, and administrative regulation that may be disproportionate to their value. This is not to say that no malfeasance or misfeasance has occurred; it is merely to say that a considerable amount of government time and energy appears to have been devoted to a rather small (in terms of relative dollars) asset management problem. For a number of years the directors and trustees of charitable organizations have managed to perform their fiduciary obligations without the large-scale intervention of the states’ attorneys general or government regulators. In California, the activities of charitable organizations, including hospitals, are not “micro-managed” by the Attorney General. There are no regulations drat tell die directors of nonprofit hospital corporations how corporate assets are to be used. Thus, the directors may decide to use charitable monies to build a new operating room or establish an out-patient clinic on the other side of the city. Of course, the law has long required the Attorney General to receive notice of substantial asset sales to make certain that the sales proceeds will remain in charitable solution,1 4 9 and there is no serious objection to this kind of notice provision. California’s 128 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospital conversion legislation is consistent with this tradition but it does considerably more. Aside from die politics of Consumers Union and other advocacy groups, what is the reason for the Attorney General’s micro-management of hospital conversion proceeds? Under the doctrine of cy pres, a court of competent jurisdiction, acting in concert with the Attorney General, may alter or amend a charitable organization’s governing document to take into account a change in circumstances. This is certainly a good thing because changes do occur over time. In almost all the hospital conversions, however, the Attorney General has placed in the revised governing document (die restated articles of incorporation) considerable detail regarding mandatory charitable expenditures, so much so that some of the mandatory provisions are almost unintelligible. As a matter of policy, there appears to be no compelling reason to subject hospital conversion proceeds to their current level of micro-management Indeed, the law should permit the directors or trustees of a conversion foundation to exercise their best judgment regarding the foundation’s charitable expenditures for the community’s benefit just as the law currently permits the directors or trustees of any other charitable organization to make similar decisions. Directors and trustees need flexibility to respond to changing community demographics and needs. The law of charitable organizations requires directors and trustees to fulfill their fiduciary obligations. To assure that die directors and trustees of charitable organizations will fulfill those obligations, they must be accountable to the organization’s stakeholders (i.e., donors, potential beneficiaries, actual beneficiaries, and regulators). Accountability requires reporting and disclosure to stakeholders so that the stakeholders can monitor 129 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. fiduciary activities and, if necessary, compel by regulatory or judicial intervention a change in those activities. Although current law provides for die possibility o f government intervention,1 3 0 it does nothing to remedy die asymmetry of information that now exists; i.e., the directors or trustees of a charitable organization may know that their stewardship is poor but the organization’ s stakeholders might be ignorant of that fact California’s hospital conversion law contains no statutory provision to remedy this problem. To improve stakeholder accountability and permit government intervention when it is necessary, hospital conversion foundations should be required to make appropriate financial and operating reports available to the public and regulatory authorities. California’s hospital conversion law contains no provision for public accountability. In addition, making ‘ 'public members” and citizen advisory committees mandatory should be adequate to address any community concerns regarding the use of conversion proceeds for charitable purposes. This is because the public, and not the Attorney General or an unrepresentative consumer advocacy group, should determine how the conversion foundation should use its assets for the community’s benefit Thus, California’s hospital conversion law needs should be amended to provide for the addition of either public board members or citizen advisory committees so that a conversion foundation’s directors can receive appropriate community program expenditure guidance. This will remove the Attorney General from his position as the “micro-manager” of foundation spending and allow him to devote his time to true oversight activities. 130 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Chapter 3 1 See Calif. Corp. Code §5917,5923 (Deering’ s 2000). 2 See Nancy M . Kane, “Some Guidelines for Managing Charitable Assets from Conversions,’ ' 16(2) Health Affairs 229 - 237 (March/April 1997). 3 See Grantmakers in Health, “A Profile of N ew Health Foundations” (Washington, D.C., M arch 2001), available at www.aih.oro. There appears to be a disparity between die information that is contained in the most recent Grantmakers in H ealth profile and the information that is available from Irving Levin Associates, Inc. According to Levin, for the years 1994 through 1997, there were at least 738 nonprofit community hospital sales to “for-profit” hospitals throughout the United Stales: Year 1994 1995 1996 1997 Number of hospitals 73 226 1 91 238 Total purchase price (billions of dollars) $1,483 $8,609 $2,244 $2,126 Over the four-year period shown in the above table, total non-profit hospital sales proceeds amounted to almost $15 billion dollars. This $15 billion dollar figure, however, is not the amount that is available for charitable use: the amount of outstanding hospital bonds and other indebtedness not assumed by the “for-profit” acquiring hospital corporations must be subtracted from the gross cash sales proceeds to arrive at the net amounts available for charitable use. S ee Irving Levin Associates, Inc., The Hospital Acquisition Report. 4th ed. (New C aiman, C T : Irving Levin Associates, 1998), p. 6. 4 Grantmakers in Health claims that die 1 9 9 8 sale of Queen of Angels—Hollywood Presbyterian Medical Center to Tenet HeahhSystem Hospitals, Inc. has produced the largest hospital-funded health care charitable organization reported to date, with year 2000 assets of approximately $400 million. This sam e figure appears on QueensCare’s Internal Revenue Service Form 990 for die year ended June 30, 2000. I am unable to reconcile the $400 million asset figure with th e California Attorney General's public statement that the Queen of Angels hospital sale to Tenet produced $272 million for charitable purposes. See California Attorney General Press Release No. 98-069 (M ay 15,1998). 5 Julio Mateo and Jaime Rossi, “White K nights or Trojan Horses? A Policy and L egal Framework for Evaluating Hospital Consolidations in California,” (San Francisco: Consumers Union, April 1 9 9 9 ), available only in PDF form at from www.consumersunion.om/healttVwhite knjqhts.htm. 1 3 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 6 M y calculation appears in Appendix B (Technical Appendix to Chapter 2). 7 See Appendix B (Technical Appendix to Chapter 2). 8 See Stephen T. Braun, ‘ ‘ Acquisitions of Exem pt Hospitals by Investor-Owned Companies,’ * in Forum on Health Law of die American Bar Association, Health Care Mergers and Acquisitions (Chicago: American Bar Association, M onograph 4, December 1995). This amount is S 5 million more than the S272 m illion figure contained in the California Attorney General’s press release. However, for accounting purposes the difference is immaterial. 1 0 Additional information is contained in Appendix B , the Technical Appendix to this chapter. 1 1 These statistics are available on the California Attorney General’s website, w w w .caaq.state.caus. Private foundations (i.e., charitable organizations that do not raise funds broadly from the public) account for assets of S 5 2 billion or approximately 25 percent of California’s total charitable asset base. See James M . Ferris and Marcia K . Sharp, “California Foundations: A Snapshot,” The Center on Philanthropy and Public Policy, University of Southern California (February 2001), www.usc.edu/philairthroov. 1 2 See die California Attorney G eneral’s website, www.caaa.state.ca.us. 1 3 See Janies M . Ferris and Elizabeth Graddy, “Healthcare Philanthropy in California: Assessing the Landscape of Health Grantmaking,” The U S C Nonprofit Studies Center, School of Policy, Planning and Development, University of Southern California (August 2000). According to the authors, more than 20 conversion foundations, including both hospital and health service plan or health maintenance organization (HM O) conversion foundations, account for more than $ 7 billion in charitable assets. Two H M O conversion foundations account for more than $4.6 billion in charitable assets: The California E ndow m ent ($3.5 billion in assets) and the California Wellness Foundation (Sl.l billion in assets). The charitable proceeds attributable to hospital conversion set-asides are relatively small. 1 4 See generally George T. Bogert, Hornbook on the Law o f Trusts, 6* ed. (St. Paul, M IN N : W est Publishing Co., 1987), ch. 6. 1 5 For example, see John H . Goddeeris and Burton A . Weisbrod, “Conversion from Nonprofit to For-Profit Legal Status: Why Does It Happen and Should Anyone Care?” 17(2) Journal o f Policy Analysis and Management 215 - 233 (Spring 19 9 8 ). 1 6 See 26 Code of Federal Regulations § l.501(cX3)-l(bX4) (2000). 1 7 The managers (Le., directors or trustees) of nonprofit public benefit or charitable organizations do not own any equity in the firms or organizations they manage. Consequently, there is always the risk that in exercising their managerial and fiduciary responsibilities they might exercise their own preferences for charitable giving as opposed to taking into account die community’ s preferences (and welfare needs) for charitable giving. For a discussion of agency theory in 132 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. general, see Jay B. Barney and W illiam G. Ouchi (eds.), Organizational Economics (S an Francisco: Jossey - Bass Publishers, 1990), ch. 4. 1 8 For an explanation of the tax expenditure concept, see Stanley S. Surrey and Paul R. M cDaniel, Tax Expenditures (Cambridge, M A : Harvard University Press, 198 5 ). See also Christopher Howard, The Hidden Welfare State: Tax Expenditures and Social Policy in the United States (Princeton, NJ: Princeton University Press, 1997). 1 9 Stanley S. Surrey and Paul R. McDaniel, Tax Expenditures (Cam bridge, MA: H arvard University Press, 1985), ch. 4. 2 0 See Nancy M . Kane, “Some Guidelines for Managing Charitable A ssets from Conversions," 16(2) Health Affairs 229 - 237 (M arch/April 1997). 2 1 Whether government intervention in health care is justified or not is beyond the scope of this essay. In economic theory, the price system should lead to die efficient allocation of health resources except where there is market failure due to the existence of public goods, externalities, or information asymmetries. See Charles E. Phelps, Health Economics (New Y ork: HarperCollins, 1992). Unfortunately, government policies have created supply and dem and distortions. Mark V. Pauly, “ Taxation, Health Insurance, and Market Failure in the M edical Econom y,” 24(2) Journal o f Economic Literature 629 - 675 (June 19 8 6 ). 2 2 Hairy Snyder and Deborah Cowan (eds.), “Building Strong Foundations: Creating Community Responsive Philanthropy in Nonprofit Conversions,” (San Francisco: C onsum ers Union, 2000). 2 3 In 1944, Congress enacted the Hill-Burton Act to provide federal funds to assist public and non profit hospitals. See Tide 42, United States Code, § 29 li. The last appropriation under the A ct appears to have been made in 1 9 7 4 . 2 4 For example, in 1964 the City of Palm Beach Gardens, Florida, received $400,000 in federal funds to construct a public hospital for its 2,000 inhabitants. An “expensive and useless w hite elephant,” the hospital was sold in 1 9 6 8 to a “for profit” hospital corporation that became a subsidiary of American Medical International. Eight years later, in 1 9 76, the federal government successfully sued the City of Palm Beach Gardens to recover the federal funds that had been, in effect, diverted to the “for profit” enterprise. To the surprise of hospital’ s c orporate owner, the United States Court of Appeals for the Fifth Circuit ruled that H iU -B urton recoveries are not subject to any statute of limitations. See United States v . City o f Palm Beach Gardens, 466 F . Supp. 1 1 5 5 (S J). Fla. 1979), rev’ d and remanded, 635 F.2d 337 (5* Cir. 1 9 8 1 ), cert, denied, 454 U.S. 1 0 8 1 (1981). 2 5 See, e.g.. United States. V . St. John’ s General Hospital et aL, 875 F.2d 1 0 6 4 (3rd Cir. 1989). 2 6 The twenty-year period is specified by statute. See US. v . NBC Bank-Rockdale, 1 F3d 63 (5* Cir., 19 9 3 ) (holding that after 20 years there is no transferee repayment liability). Congress could have proscribed a shorter or longer recovery period. 2 7 The last appropriation appears to have been made in 1974 and, therefore, the 20-year statutory recovery period should have expired in 1994. See Title 42, United States Code, §§ 291a, 29li. 133 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2 8 See, e.g„ Robin W . Boadway and David E. Wildasin, Public Sector Economics, 2 “* ed. (Boston: Little, Brown and Company, 1984). 2 9 The proceeds from the sale of a tax-exempt charitable hospital must be transferred to either government or another charitable organization; Le^ an entity that is tax-exempt under the provisions of Internal R evenue Code of 1986, § 501(c)(3). Health maintenance organizations (H M O s) are generally classified as “social welfare" organizations under die provisions of Internal Revenue Code of 19 8 6 , § 501(cX4). Hence, while H M O or health plan conversions can fund a section 501(cX4) “social welfare” organization, a hospital sale or conversion cannot. W hen a non-profit charitable hospital is sold or converted, the proceeds must pour over and into a section 501(cX3) “charitable" organization. This distinction is im portant fix’ regulatory reasons. 30 See generally Forum on H ealth Law of the American Bar Association, Health Care Mergers and Acquisitions (Chicago: A m erican Bar Association, Monograph 4,1995). 3 1 See Douglas M. Mancino, “Exem pt Entities: Joint Ventures, Virtual Mergers and Conversions of Status," 50 Major Tax Planning 8-1 - 8-62 (1998). See also Douglas M . Mancino, “Converting the Status of Exem pt Hospitals and Health Care Organizations," 9(1) Journal o f Taxation o f Exempt Organizations 16 (July/August 1997). 3 2 The gross sales proceeds from the hospital’s sale must be reduced by any liabilities not assumed by the “for-profit" purchaser. For example, a charitable hospital corporation m ight sell its only hospital for S50 million cash to a “for-profit" hospital chain. If, due to die previous sale of tax- exempt bonds or the existence of other unassumed liabilities, the selling corporation is left with indebtedness of $45 million, only $5 million would be available for charitable purposes. The selling corporation’ s board m ight consider itself unable to effectively and efficiently manage such a small ($5 million) fund. 3 3 Speaking generally, a section 501(cX3) charitable corporation can merge with or into another section 501(cX3) corporation without any taxable gain or loss or other adverse tax implications. Thus, H could merge with an existing charitable corporation that would be the survivor. For reasons of legal liability, however, such a merger would be unlikely to occur. 3 4 The form was downloaded from the California Attorney General’s charities database, www.caan state ca.us/chanties. 3 5 Internal Revenue Code of 1 9 8 6 , § 508(a). 3 6 These and other requirements are discussed in Frances R. Hill and Barbara L. Kirscbten, Federal and State Taxation o f Exempt Organizations (Boston: Warren, Gorham & Lam ont, 1994). 3 7 W hether or not hospitals should be tax-exempt organizations is beyond die scope of this dissertation. See, e.g., Frank A . Sloan, “Commercialism in Nonprofit Hospitals," 17(2) Journal o f Policy Analysis and Management 234 - 252 (Spring 1998); Curt A. Kram er, “Nonprofit Hospitals: A Charitable Cause Or Unjustified Tax Subsidy?" 19(3) The Exempt Organization Review 341 - 374 (March 1998); David A. Hyman, “The Conundrum of CharitabOity: 134 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reassessing Tax Exemption for Hospitals," 16 American Journal o f Law A Medicine 327- 380 (1990); Theodore R . Mannor, Mark Schlesjnger, and Richard W . Smithey, “A New Look at Nonprofits: Health Care Policy in a Competitive Age,” 3 Y a le Journal on Regulation 313 - 349 (Spring 19 8 6 ). The tax benefits of nonprofit hospitals are described in William M . Gentry and John R. Penrod, "The Tax Benefits of Not-For-Profit Hospitals," NBER Working Paper Series (Working Paper 6435) (Cambridge, M A : National Bureau of Economic Research, February 1998). 3 8 Operating hospitals do not have to worry about "private foundation" status because of a specific exemption. See Internal Revenue Code of 1986, § 509(aXl)- When the hospital is sold, however, die selling nonprofit corporation may be classified as a private foundation. 3 9 Internal Revenue Code of 1986, § 509(a). 40 See generally Bruce R . Hopkins and Jody Blazek, Private Foundations: Tax Law and Compliance (N ew York: John Wiley & Sons, 1997). 4 1 Internal R evenue Code of 1986, §§4940,4942. 4 2 Internal Revenue Code of 1986, § 4943. 4 3 See generally 26 Code of Federal Regulations § 1.507-9 (2000). 4 4 See Grantmakers in Health, "A Profile of New Health Foundations," (Washington, D C : Grantmakers in Health, March 2001). The GIH report classifies all hospital conversion foundations as section 50I(cX3) charitable organizations. The report classifies some HM O or health service plan conversion foundations as section 501(cX 4) social welfare organizations. 4 5 See Nancy M . Kane, "Some Guidelines for Managing Charitable Assets from Conversions," 16(2) Health Affairs 229 - 237 (March/April 1997). 4 6 The principal statute is Internal Revenue Code of 1986, § 4958. For a detailed explanation of the new provision, see Staff of the Joint Committee on Taxation, General Explanation o f Tax Legislation Enacted in the lOf* Congress (Washington, D.C.: U.S. Government Printing Office, 19%), pp. 54-63. 4 7 See Grantmakers in Health, "A Profile of New Health Foundations" (Washington, D.C., March 2001), available at w w w .a ih .o ra . 4 8 See Calif. Corp. Code § 5260 (Deering’ s 2000). 49 A charitable organization may elect to be governed by a "bright-line" test for lobbying activities. See Internal R evenue Code of 1986, § 501(b). 50 For a discussion of the tax status of charitable organizations that receive hospital sales or conversion proceeds, see Christopher R . Hoyt, "Creating Supporting Organizations of 135 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Community Foundations from Nonprofit Hospital Sales,” 17(2) T h e Exempt Organization T a x Review 265 - 268 (August 1997). 5 1 See the Supervision of Trustees and Fundraisers for Charitable Purposes Act, C aL Gov't C ode § \2580 et seq. For a history of the Act, see W allace Howland, “The History of the Supervision of Charitable Trusts and Corporations in California,” 13 U CL A Law Review 1029-1040(1966). 5 2 Author’ s conversation with H. Chester H orn, Jr., Deputy Attorney General, State of California. 5 3 Ibid. 5 4 6 1 CaL2d 750,755 (1964). 5 5 Ibid., at 754. 3 6 See Susan Rose-Ackerman, Rethinking the Progressive Agenda: T h e Reform o f the Amer ican Regulatory State (New York: The Free Press, 1992), ch. 1 2 . 5 7 Ibid. 5 8 Calif. Corp. Code §§ 300(a), 5210 (Deering’ s). 5 9 For a complete explanation of directors’ duties and responsibilities, see American Law Institute, Principles o f Corporate Governance: Analysis and Recommendations (Philadelphia: A m erican L aw Institute, 1994). Although p repared for use by general business corporations, many of the corporate governance recom m endations are applicable to charitable corporations. 6 0 See, generally, J. Patrick W haley, ed., Advising California Nonprofit Corporations. 2 “ d ed (Berkeley: Continuing Education of the B ar, 2000), ch. 8. 6 1 Calif. Corp. Code § 500 (Deering’s 2000) (ordinary business corporation). 6 2 California Corp. Code § 400 (Deering’s 2000). In California, the sale of corporate stock is governed by the Corporate Securities Law of 1968, Corp. Code § 25000 et seq. (Deering's 2000). 6 3 W hile this may be true for small, closely held business corporations, it is not true for large corporations whose stock is traded on public exchanges. Because of the cost of acquiring information, it is more efficient for a disgruntled public stockholder to sell his stock than to invest time and effort in mounting a campaign to oust a disfavored director. Nevertheless, a stockholder with adequate time and financial resources can m ake life difficult for a disfavored board member. 6 4 See Mancur Olson, The Logic o f Collective Action: Public Goods and the Theory o f G ro u p s (Cambridge, M A : Harvard University Press, 1965). 136 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 6 5 Calif. Corp. Code § 5410 (Deering’ s 2000). Upon dissolution, however, a nonprofit public benefit corporation m ay distribute assets to an individual or other person if a valid condition subsequent requires the distribution to be made. Corp. Code § 6715 (Deering’s 2000). 6 6 See Calif. Corp. Code § 5220(d) (Deering’ s 2000). Under this provision, the corporation’ s articles of incorporation or bylaws may designate or select individuals to serve as dire ctors for an indefinite period of tim e. 6 7 Calif. Corp. Code §5142 (Deering’ s 2000). 6 8 See, e.g., Steven V. M ann and Neil W . Sicherman, “The Agency Costs of Free Cash Flow: Acquisition Activity and Equity Issues,” 64(2) Journal a f Business 213 - 227 (April 1991). 6 9 See H enry Hansmann, Th e Ownership o f Enterprise (Cambridge, M A : The Belknap Press of Harvard University Press, 19%), pp. 17 - 1 8 . 7 0 Calif. Corp. Code § 5 1 4 2 (Deering’s 2000). 7 1 For the connection betw een insiders’ pet causes, corporate philanthropy, and managerial discretion, see Faith Stevelm an Kahn, "Pandora’s B ox: Managerial Discretion and the Problem of Corporate Philanthropy,” 44 U C L A Law Review 579 - 676 (Februrary 1997). 7 2 Almost all major professional firms require partners and other senior m anagement executives to become m embers of at least one nonprofit public benefit corporation board for "business development" purposes. The large accounting and law firms are usually able to "plant” their key people in highly visible com m unity organizations. 7 3 For a discussion of directors and officers’ responsibilities, see Smith, Bucldin & Associates, T h e Complete Guide to Nonprofit Management (New York: John Wiley & Sons, 1994), ch. 2. 7 4 Melissa Middleton, "Nonprofit Boards of Directors: Beyond the Governance Function,” in Walter W . Powell, ed. Th e Nonprofit Sector: A Research Handbook (N ew Haven, CT: Yale University Press, 1987), p. 1 5 2 . 7 3 The author, during his years at KPMG Peat Marwick, was a member of two nonprofit public benefit corporation boards, one of which was a psychiatric hospital under contract with die County of Los Angeles. Monthly hospital board meetings (there were m ore than 1 2 directors) began at 1 2 noon and ended promptly at 1 :1 5 pm . No important hospital business was ever discussed and prior to the author’s becoming a member of the board hospital financial statements were never issued to board members. 7 6 The board is entitled to fix the compensation of its members and officer compensation as w elL See Calif. Corp. Code § 5235 (Deering’ s). According to Abbott, Langer & Associates (Crete, Illinois), some chief executive officers (CEOs) of nonprofit organizations earn more than $300,000 annually, and a few earn more than $400,000. But the m edian annual income of a nonprofit CEO is $61,000. See Abbott, Langer & Associates, Compensation in Nonprofit 137 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Organizations. 9th ed (Crete, IL: A bbot, Langer, 1998), sum m arized at the company’ s w eb site: www.abbott-tanoer.com. 7 7 See Calif. Corp. Code § S239 (Deering’s), limiting the personal liability of H vohmteer” directors and officers of nonprofit public benefit corporations. 7 8 See die Volunteer Protection Act of 19 9 7 , Public Law No. 105-19, Title 42, United States C ode, § 1 4 5 0 1 et seq. In general, volunteers of nonprofit organizations are exempt from personal liability for acts of ordinary negligence. Certain acts (e.g ~ , criminal conduct and gross negligence), however, are not excused The new federal law preempts conflicting state law. 7 9 See, e.g., Canice Prendergast, “A Theory of ‘Yes Men’," 83(4) American Economic Review 757- 770 (September 1993). 8 0 Calif. Corp. Code § 5151 (Deering’s 2000). There is no statutory maximum number of directors. 8 1 See J. Patrick Whaley, ed.. Advising California Nonprofit Corporations. 2nd ed (Berkeley. Continuing Education of the Bar, 1998), ch. 9. 8 2 Calif. Corp. Code § 5410 (Deering’s 2000). 8 3 Calif. Corp. Code § 5311 (Decring’s 2000). 8 4 Calif. Corp. Code § 5320 (Deering’ s 2000). Depending upon the corporation’ s articles or bylaws, in theory a member can be expelled but in practice expulsion would seem to be extremely difficult See Calif. Corp. Code § 5341 (Deering’ s 2000). 8 3 J. Patrick Whaley, ed. Advising California Nonprofit Corporations. 2nd ed (Berkeley Continuing Education of the Bar, 1998), § 93. 8 6 See Calif. Corp. Code § 5310 (Deering’ s 2000). 8 7 Calif. Corp. Code § 5110 etseq. (Deering’ s 2000). 8 8 See Calif. Corp. Code § 5310(a) (Deering’ s 2000). 8 9 Calif. Corp. Code §5212 (Deering’ s 2000). 9 0 Calif. Corp. Code § 5211(a)(7) (Deering’ s 2000). 9 1 Calif. Corp. Code § 5151(c)(4) (Deering’s 2000). 9 2 See Calif. Corp. Code §5142 (Deering’s 2000). 9 3 See Calif. Corp. Code § 5142 (Deering’ s 2000) and Justice McComb’s dissenting opinion in Holt v . College o f Osteopathic Physicians and Surgeons, 6 1 Cal. 2d 750 (1964). 138 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 9 4 See Mary Gabay & Sidney M . W olfe, “Who Controls die Local H ospital? The Current Hospital Merger and Acquisition Craze and the Disturbing Trend of Not-For-Profit Hospital Conversions to For-Profit Status,” Public Citizens Health Research Group, June 19 9 6 . 9 5 Calif. Corp. Code §5111 (Deering’s 2000). 9 6 Austin Waketnan Scott, Abridgment o f the Law o f Trusts (Boston: Little, Brow n and Company, I960), pp. 663-690. 9 7 L. A. Sheridan and George W . K eeton, The Law o f Trusts. 11* ed. (Chichester, England: Barry Rose Publishers Ltd., 1983), pp. 166-173. 9 8 The income tax definition of the term “charitable” is consistent w ith the preamble to the Statute of Charitable Uses. See 26 Code of Federal Regulations § 1 .5 0 1 (c)(3)-l(dX2) (2000). 9 9 6 1 CaL2d 750 (1964). 1 0 0 66 C aL AppJd 359 (Cal. C L A pp. 1977). 1 0 1 66 C aL App Jd at 366. 1 0 2 Charitable corporations may voluntarily file for bankruptcy but they cannot be the subject of involuntary bankruptcy petitions. See Title 1 1, United States Code, § 303(a). 1 0 3 See George T. Bogert, Trusts. 6th ed. (S L Paul: West Publishing C o., 1987), pp. 519-527. 1 0 4 343 F.2d 594 (4th Cir. 1965). 1 0 5 Calif. Corp. Code § 5917(e) (Deering’ s 2000). 1 0 6 1 1 California Code of Regulations § 9993(eX3XGXi)(a), (b) (2000). 1 0 7 Information about the Lewin G roup can be obtained from its web site: w w w .ie w in .c o m . Headquartered in Washington, D .C _ the company maintains an office in San Francisco. 1 0 8 See California Attorney General Press Release Nos. 98-066 (May 4,1998) and 98-069 (May 1 5, 1998). These press releases include documents entitled, “Sum m ary of Queen of Angels— Hollywood Presbyterian Revised Proposed Transaction,” and “R eport to the Public Regarding the Proposed Sale of Queen of A ngels—Hollywood Presbyterian M edical Center (Queen of Angels) to Tenet Healthcare (Tenet).” 1 0 9 See Consumers Union West Coast Regional Office Press Releases dated M ay 11,1998 and May 1 4 , 1998, originally published at www.consunion.oni/health/queenfnfowc59a.htm. 1 1 0 See 1 1 California Code of Regulations § 9993(eX3XGXiXa), (b) (2000). 139 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 1 1 California Attorney General Press Release No. 97-043 (April 22, 1997). 1 1 2 The company is based in El Segundo, California and information about its consulting activities can be obtained from its web site: www.thecatndenarmiD.com. 1 1 3 1 1 California Code of Regulations § 9993(eX3XGXD(a) (2000). 1 1 4 The benefits of tax-exempt status include exemption from federal and state incom e tax, exemption from property tax, the right to receive tax-deductible contributions from donors, and, in California at least, the right of eminent domain to acquire real property. See Calif. Health & Safety Code § 1260 (Deering’s 2000). 1 1 5 Revenue Ruling 56-185, 1 9 5 6 -1 Cumulative Bulletin 202. 1 1 6 Section 501(cX 3) of the Internal Revenue Code of 1954 is essentially similar to section 501(cX3) of the Internal Revenue Code of 1986. 1 1 7 Revenue Ruling 69-545, 1969-2 Cumulative Bulletin 1 1 7 . See also Revenue Ruling 83-157, 1983-2 Cumulative Bulletin 94. 1 1 8 For this policy recommendation, see Shelley A. Sackett, “Conversion of Not-for-Profit Health Care Providers: A Proposal for Federal Guidelines on Mandated Charitable Foundations,’ ’ 10 Stanford Law & Policy Review 247 - 257 (Spring 1999). 1 1 9 See Calif. Health & Saf. Code § 127340(d) (Decring’ s 2000). 1 2 0 Calif. H ealth & Saf. Code § § 127340 - 127365 (Deering’ s 2000). 1 2 1 California Attorney General Press Release No. 97-044 (April 22, 1997). 1 2 2 See Calif. Health & Saf. Code § 127345(c) (Deering’ s 2000). 1 2 3 Calif. H ealth & Saf. Code § 127345(cX8) (Deering’ s 2000). 1 2 4 See California Committee Analysis, “Digest of Hearing on Senate Floor Bill No. 848,” January 28.1998. Available online at either www.sen.ca.gov or www.leQinfo.ca.gov. 1 2 3 The Senator himself died in February 2000. 1 2 6 See California Committee Analysis, “Digest of Hearing on Senate Floor Bill No. 848,” January 28.1998. Available online at either www.sen.ca.aov or www.leoinfo.ca.gov. 1 2 7 “Social w elfare” organizations are tax-exempt under the provisions of Internal Revenue Code of 1986, § 501(cX 4), but “Charitable’ ’ organizations are tax-exempt under the provisions of Internal Revenue Code of 1986, § 501(cX3). The distinction is important for several reasons. First, contributions or donations to social welfare organizations are not deductible for incom e tax 140 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. purposes under Internal Revenue Code of 1986, § 170. Second, under the federal incom e tax law, social welfare organizations are less regulated than charitable organizations; e.g., social welfare organizations are not subject to the “private foundation” rules, which are contained in Internal Revenue Code of 1986, § 509. Under the income tax regulations, there may be very little distinction, if any, between “social welfare” organizations and “charitable” organizations. In feet, it is useful to com pare the “social welfare” definition with the “charitable” definition. Under 26 Code of Federal Regulations § 1.501(cX4)-l(aX2) (2000), a social welfare organization is one that is “primarily engaged in promoting in some way the com m on good and general welfare of the people of the com m unity.” Under 26 Code of Federal Regulations § 1 -501(cX3)-I(d)(2) (2000), the “promotion of social welfare" can be a charitable purpose. The Internal Revenue Service would seem to have an interest in classifying “social welfare” organizations as “charitable” organizations for regulatory and enforcement purposes. However, it has been reluctant to do so. 1 2 8 Calif. C orp. Code § 5930 (Deering’ s 2001). 1 2 9 A digest of the legislative history of Assembly Bill No. 2276 is available from Lexis-N exis California library. 1 3 0 The legislature directed the Attorney General to consult with consumer and community groups and to subm it recommendations to the legislature by March 1,2001. If these recommendations have been submitted to die legislature, they have yet to be published on the Attorney G eneral’s website. 1 3 1 Utah County v . Intermountain Health Care, 709 P.2d 265 (Utah, 1985). 1 3 2 See Alice A . Noble, Andrew L . Hyams, and Nancy M . Kane, “Charitable H ospital Accountability: A Review and Analysis of Legal and Policy Initiatives,” 26(2) Journal o f L a w . Medicine & Ethics. 116-137 (1998). 1 3 3 For one thing, the successor charitable organization’s board of directors and officers m u st interpret the Attorney General and the court’ s charitable expenditure guidelines and reduce th em to practice. The diseases of administrative language, including ambiguity, vagueness, and imprecision, are well known. See, e.g., Reed Dickerson, Th e Fundamentals o f Legal Drafting (Boston: Little, Brown and Co., 1965). Hence, since optimum clarity in legal draftsmanship is an impossible goal, there will always be some public policy deviations in the charitable expenditure process. 1 3 4 For a m ore extensive discussion of principal-agency problems in government, see D. R oderick Kiewiet and Mathew D . M cCubbins, The Logic o f Delegation: Congressional Parties and the Appropriations Process (Chicago: The University of Chicago Press, 1991), ch. 2. 1 3 5 According to a conversation with H . Chester Horn, Jr., Deputy Attorney General, State of California, the Attorney General’ s lack of resources (human and financial) to critically review the reports of charitable organizations means that his office w ill investigate a charity only in the event of a serious and monetarily substantial complaint by an informed “whistle blower” such as a disgruntled director, officer, or major donor. 1 4 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 For an explanation of the p ertinent cash basis and accrual basis financial statements, see M alvern J. Gross, Jr., Richard F. Larkin, Roger S. Bruttomesso, and John J. McNally, Financial and Accounting Guide for Not-for-Profit Organizations. 5* ed. (New York: John Wiley & 1995). 1 3 7 Although the results of adverse tax audits conducted by either the Internal Revenue Service or the Franchise Tax Board should be reported to die Attorney General's office for appm priatc follow up w ork, this reporting does not always occur. For one th in g , tax auditors m ay be oblivious to violations of die law of charitable trusts. For another. Internal Revenue Service audit guidelines may prohibit the disclosure of adverse tax information to the Attorney General I lit Calif. Corp. C ode § 5924(d) (Deering’s 2000). See the limitation in Calif. Corp. Code § 5924(dX3) (Deering’s 2000). 1 4 0 See Internal Revenue Code of 1986, § 6104(b). 141 See Internal Revenue Code of 1986, § 6104(d). 1 4 2 See 26 Code of Federal Regulations § 301.6104(d>2 (2000). 143 Unfortunately, the Attorney General’ s postings are incomplete and it may take several years for all nonprofit organization information to be available to the public. 144 See Financial Accounting Standards Board, Statement of Financial Accounting Concepts N o . 4, “Objectives of Financial Reporting by Nonbusiness Organizations” (Norwalk, CT: Financial Accounting Standards Board, December 1980). 145 See Regina E Herzlinger, “Can Public Trust in Nonprofits and Governments be R estored?” 74(2) Harvard Business Review 97-107 (March-April 1996), p. 97. 1 4 4 Calif. Corp. Code § 5930 (Deering’s 2001). 147 „ See www.caaQ.state.ca.us/charities. 144 r» See Julio M ateo and Jaime Rossi, “White Knights or Trojan Horses? A Policy and Legal Framework for Evaluating Hospital Consolidations in California,” (San Francisco: Consum ers Union, April 1 9 9 9 ), Table 4, available only in PDF format from www.consumefSunion.om/healtti/Wtiite kruahts.htm. 149 See Calif. C orp. § § 5910 - 5913 (Deering’s 2000). 1 5 0 See Calif. C orp. Code §§ 5142,5250 (Deering’s 2000). 142 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 4 Regulatory Issues in Hospital C onversions 4.1 Overview During the past decade, health care advocates and public policy commentators have opined that hospital conversions should be strictly regulated for three principal reasons: first, to minimize the loss of essential community medical and health care services; second, to prevent the capture of public trust fund dollars by private individuals (so-called private inurement and private benefit); and third, to make certain that hospital sale or conversion proceeds will be used to provide appropriate substitute health care benefits to community residents.1 The driving force behind these concerns has been the threat of opportunistic decision-making due to, at least in part, the veil of secrecy that is pervasive in the management and regulation of nonprofit community hospitals and other charitable organizations. California’s hospital conversion law, which became effective on January 1, 1997, is substantially responsive to these and other concerns. There are, however, some significant public policy issues which this chapter seeks to explicate. As previous chapters have already articulated, the public interest in hospital conversions stems from the fact that the assets of a tax-exempt nonprofit community hospital corporation are impressed with a charitable trust2 Consequently, when a nonprofit 143 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. community hospital is sold, the act o f monetization by commercial transfer does not abrogate the public trust or otherwise eliminate the so-called nondistribution constraint3 The proceeds from the sale o f a nonprofit charitable hospital are required to remain in charitable solution indefinitely and be applied to charitable purposes that are allowable under the terms of the nonprofit hospital corporation’s governing instrument, typically the nonprofit corporation’s articles of incorporation.4 If the governing instrument is inflexible or manifests a charitable purpose that is impracticable to carry out, a court of competent jurisdiction (in California, the superior court of the county in which the nonprofit hospital is located), in cooperation with the Attorney General, can allow either the old nonprofit hospital corporation or a successor charitable organization to use the conversion proceeds for a similar charitable health care purpose under the common law doctrine of cy pres.5 When the board of directors of a nonprofit community hospital corporation decides to sell the hospital facility, there are usually three baseline questions: first, is the sale of the hospital permissible under the terms of the hospital’s governing instrument; second, if a sale of the hospital is permissible, is the sale a financial necessity or prudent for other business judgment reasons; third, if the hospital is sold, who should receive the sales or conversion proceeds and how should they be managed and spent? Traditionally, the first two questions have been the responsibility of the board of directors of the selling hospital, and the third question has been the responsibility of the board o f directors of the charitable organization (sometimes referred to as a “conversion foundation”) that will be responsible for managing and spending the conversion proceeds, either the old hospital corporation, which may remain in existence as a grant-making charitable organization, or a successor charitable entity to which the conversion proceeds have been transferred. 144 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In this chapter, I claim that die oversight of charitable hospitals and health care organizations, as well as charitable organizations in general, may be ineffective for three principal reasons: first, the public does not have access to sufficient information about nonprofit hospitals to understand their operations and activities; second, the public does not have the opportunity to present information or its concerns to a charitable organization’s board of directors or corporate officers or, in some cases, to government regulators; third, there is no efficient monitoring or regulatory mechanism to satisfactorily represent the public interest in charitable organizations. I offer several policy recommendations to improve the public’s ability to monitor the activities of nonprofit hospitals and other charitable health care organizations and exercise a voice in their management 4.2 The Current State of Hospital Conversion Regulation The principal regulators of hospital conversion activities are the states’ attorneys general and the Internal Revenue Service. The former are responsible for supervising charitable organizations and enforcing fiduciary obligations, and records show that even before the enactment of the Statute of Charitable Uses in 1601 the Attorney General of England exercised his common law authority to enforce charitable trusts.6 The latter is responsible for using the federal income tax laws to police the operating activities of charitable organizations to prevent improper financial benefits from accruing to private individuals. There is some regulatory overlap, and one must recognize that the abilities of both the states’ attorneys general and the Internal Revenue Service to ferret out the misappropriation of charitable assets are resource-constrained. 145 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.2.1 The Attorney General’ s Regulatory Jurisdiction In almost all states, die attorneys general can examine die financial condition and affairs of charitable organizations, including nonprofit hospitals, and exercise plenary (common law or statutory) supervisory powers over them.7 With appropriate prior knowledge, usually gleaned from a disgrunded major donor or a disaffected director or corporate officer, the attorney general of a state can intervene in a board decision to expand or contract hospital operations—even sell the hospital—if executive branch intervention is thought to be necessary to protect the public interest Thus, in 1985, the Massachusetts Attorney General intervened in the proposed sale of all the assets of a nonprofit charitable community hospital to a “for-profit’ * corporation because the sale would require the hospital corporation to divert the sales proceeds to some other charitable activity in violation of the terms of the hospital corporation’s public charter.* This kind of intervention was the exception rather than the rule because, until the early 1990s, there were relatively few sales of nonprofit community hospitals to “ for-profit” hospital chains and thus few opportunities for public interest litigation. Fueled by some exceptionally egregious but isolated early incidents involving nonprofit charitable hospitals, such as the 1981 sale of the S t Charles General Hospital in New Orleans, Louisiana for $5 million less than the hospital’s fair market value,9 and the 1983 sale of the Anclote Psychiatric Center in Tarpon Springs, Forida for S23 million less than the hospital’s fair market value,1 0 the growing pace of nonprofit community hospital acquisitions by “for-profit” hospital chains during the early 1990s gave rise to claims by various advocacy groups that the public interest was being serious undermined. As 146 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. previously mentioned, die usual litany of complaints involved the prospect of inferior health care (the assumption being that nonprofit hospitals provide better health care than “for-profit” hospitals), die assertion that the public was not getting its money’s worth when the hospitals were sold (which was true in the case of S t Charles General Hospital and Anclotc Psychiatric Center), and the contention that the sales proceeds might not be used to replace “lost” health care benefits. California, the bellwether state, was among the first to enact responsive hospital conversion legislation." With the support of Consumers Union, the California Medical Association, the American Association of Retired Persons, and the California Attorney General, California’s hospital conversion legislation, enacted in 1996 and effective for nonprofit hospital sales transactions occurring on or after January 1, 1997, became law.1 2 California’s hospital conversion law is comprehensive because it provides for the Attorney General’s involvement in almost all aspects of hospital conversion proceedings. Under California law, a selling nonprofit hospital must be prepared to do at least each of the following:1 3 • Prior to any sale, lease, or other transfer of a “material amount” of a nonprofit hospital’s assets, submit written notice to die Attorney General about the pending transaction so that the Attorney General can review the transaction and, if necessary, prevent the transfer from being consummated. For this purpose, a “material amount” is more than 20 percent of the nonprofit hospital’s assets. 147 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. • Demonstrate financial necessity for the sale or transfer and show that the transaction is “in the public interest.” • Satisfy the Attorney General that the selling hospital will receive “fair market value” for its charitable assets. • Satisfy the Attorney General that there are no impermissible financial arrangements or benefits between the management of the selling hospital and the management of the acquiring hospital. • Satisfy the Attorney General that all other terms and conditions of the proposed sale or other transfer are “fair and reasonable” to the selling corporation. • Assist the Attorney General to make certain that the proposed use of the sales proceeds will provide comparable community health care benefits “consistent with the [selling hospital’s] charitable trust.” The statute permits the Attorney General to exercise broad discretion. In addition to the standards that are enumerated in the statute and mentioned above, the Attorney General may consider “any [other] factors” that he deems relevant1 4 Moreover, he may hire outside experts or consultants to assist him and charge their professional fees or contract costs to the selling nonprofit hospital.1 5 The California Attorney General’s role is essentially adjudicatory because, in principal, he is charged with determining two things: first, whether or not to approve the 148 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. proposed hospital sales transaction that has been brought to his attention; second, in the event be approves die transaction, whether or not to approve the proposed use of the proceeds from the sales transaction. California’s hospital conversion law allows the Attorney General to require substantial contract changes as a condition to giving his consent to the transaction. Presumably, a party who is aggrieved or dissatisfied because of the Attorney General’s proposed contract changes or modifications may seek independent judicial review, although this is not completely clear.1 6 California’s lead in die hospital conversion field subsequently influenced the National Association of Attorneys General to adopt, in 1998, similar model health care conversion legislative guidelines for use by all the states.1 7 By the end of 1998, more than two-thirds of the state legislatures had considered specific legislation to regulate hospital conversions, and at least twenty-four states had adopted specific regulatory legislation.1 8 Unfortunately, neither California law nor the model guidelines suggested by the National Association of Attorneys General address some of the broader issues that are pertinent to the governance of charitable organizations in general and to hospital conversions in particular. The Attorney General’s statutory supervisory powers notwithstanding, there are some significant unsettled public policy issues. First, under current law there is little opportunity for the public to participate in baseline decision-making. Although theory suggests that nonprofit public benefit corporations represent the privatization of government spending decisions,1 9 California law does not permit the public to attend nonprofit hospital board meetings for the purpose of presenting information to the selling hospital’s board of directors or otherwise attempting to influence the decisions o f nonprofit hospital management Under California’s hospital 149 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. conversion law, prior to giving his consent to a sale of nonprofit hospital assets the Attorney General must conduct at least one public meeting.2 0 Unfortunately, since this meeting is required to be held only after a pending hospital sales transaction has been brought to the Attorney General for his approval,2 1 the public meeting requirement is essentially anticiimactic. Effective representation of the public would seem to require meaningful public participation in the hospital conversion process and the public’s ability to present its concerns to the Attorney General for his consideration.2 2 More important, there is nothing in the law that requires the Attorney General to give due consideration to the public’s written comments or evidentiary submissions about a particular proposed sales transaction. Second, once the hospital is sold, there is nothing in the law that requires the charitable organization which is responsible for managing and spending the conversion proceeds to listen to the concerns of potential charitable beneficiaries or other members of die public. The Attorney General, in cooperation with a superior court, is responsible for making certain that the use of the sales or conversion proceeds will be “consistent with the charitable trust on which the assets [were] held” by the selling nonprofit hospital or health facility.2 3 Again, there is no requirement in die law that the Attorney General give due consideration to the public’s written comments or other submissions concerning the proposed use of hospital conversion proceeds. It is the public’s right to make submissions, with the expectation that they will be read and considered, but not necessarily adopted, that is critical to the administrative law process. Moreover, there is nothing that requires the superior court in a cy pres proceeding to consider public comments or written submissions from potential beneficiaries. Indeed, for this purpose the Attorney General is the public. 150 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Whether and to what extent the Attorney General should be deemed to represent the public interest is an important question.2 4 Recently, the Attorney General has taken an important first step. By posting notices of nonprofit hospital transactions on his website, www.caao.state.ca.us. die public can peruse important hospital conversion legal documents and valuation reports. For example, the public can read the statutory notice dated March 21, 2001 for the proposed sale of Huntington East Valley Hospital, together with pertinent legal agreements and documents (e.g., the asset sale agreement, appraisal report, health impact report, and community needs assessment).2 5 Presumably, this posting means that the public can submit facts or arguments to the Attorney General concerning die proposed sales transaction, but this should be made clear and explicit to the public reader. The posting of proposed hospital sale information on the Internet is an important first step, but local newspaper publication of the statutory notice is also important because some interested residents may not have Internet access.2 6 The next step is for the Attorney General to implement some machinery to receive the public's written submissions concerning proposed conversion transactions so that die submissions can be read and adequately evaluated by appropriate staff personnel (or even outside consultants pursuant to the Attorney General’s statutory power to engage outside experts2 7 ). This will assure the public of its right to engage government officials in an appropriate dialogue concerning a matter that is of substantial public interest and importance. The public’s right to be heard and its right to present evidence are critical to the fairness of the democratic process. 151 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.2.2 The Internal Revenue Service’ s Regulatory Jurisdiction The Internal Revenue Service has jurisdiction to affect the affairs of charitable organizations, principally for two reasons: (1) “charitable’' organizations seeking tax- exempt section 501(cX3) status must submit a written application to the Internal Revenue Service for a determination letter;3 (2) the Internal Revenue Service may revoke a charitable organization’s tax-exempt status for various income tax law violations (e.g., inurement, engaging in impermissible lobbying activities, and violations of public policy).2 9 Although charitable organizations are exempt from income tax, they are required to furnish financial and other information to the Internal Revenue Service for tax- exemption qualification and audit evaluation purposes.3 0 The most common reporting forms are Form 990 (“Return of Organization Exempt from Income Tax”) and Form 990- PF (“Return of Private Foundation”)- In theory, this information submittal is supposed to enable the Internal Revenue Service to determine inappropriate or illegal activities and the possible misappropriation of charitable assets. In practice, the tax audits of exempt organizations tend to be performed by relatively inexperienced examiners or agents and thus cursory. Tax-exempt hospitals are subject to special audit guidelines. Since 1992, income tax agents have been required to assess a hospital's compliance with the minimum “community benefit” standard (tax-exempt hospitals must provide some emergency room services to indigent patients) and ascertain the absence o f impermissible financial arrangements between the hospital and its “insiders,” usually physicians.3 1 More recently, joint ventures between tax-exempt hospitals and “for-profit” companies have come under serious Internal Revenue Service scrutiny, with die government alleging that such 152 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. arrangements mean that die tax-exempt hospital is not being “operated exclusively” for charitable purposes.3 2 Consequently, joint ventures such as die arrangement between Riverside Community Hospital and Cotumbia/HCA Healthcare are now current audit targets o f Internal Revenue Service. It has long been illegal for tax-exempt charitable organizations to provide financial benefits to “insiders” (principally substantial donors or management) or third parties. Thus, a tax-exempt hospital may not unreasonably compensate its physicians, provide inappropriate incentives to physicians for patient referrals, or make unreasonable loans to physicians or hospital management3 3 In 1996, Congress responded to die concerns of various public interest groups, including those concerned about hospital conversions, by adding section 4958 to the Internal Revenue Code of 1986.3 4 Now, the Internal Revenue Service may revoke an organization's tax-exempt status or, under section 4958, impose a special excise (penalty) tax on any “excess benefit transaction” between the organization and any officer, director, or other person “in a position to exercise substantial influence over the affairs of the organization.” 3 5 Virtually any transaction associated with a hospital conversion is potentially subject to the penalty taxes imposed by section 4958.1 6 Examples of patently obvious improper benefits or activities caught by section 4958 include:3 7 • The sale of a nonprofit hospital to a “for-profit” hospital for less than fair market value in exchange for favorable votes, coupled with the oral understanding that certain directors of the selling hospital will become directors or employees of the acquiring “for-profit” entity. 153 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. • A director of a selling nonprofit hospital becomes a director of the conversion foundation, and his new director’s remuneration is substantially greater than the value of his personal services to the foundation. • To assure a favorable vote, die “ for-profit” acquiring hospital entity agrees to lend money to a family member of the chairman of the selling nonprofit hospital’s board of directors. A ‘ Tacts and circumstances” approach will necessarily govern the application of section 4958. In principal, the California Attorney General’s hospital conversion regulations and review protocol cover the same ground,3 * although with considerably less regulatory detail. The Internal Revenue Service is not obligated to follow a state attorney general’s approval of a particular transaction; i.e., it may question and penalize a state attorney general-approved conversion transaction. Similarly, a state attorney general may question a transaction that might fail within an Internal Revenue Service-approved “safe harbor” guideline. Although section 4958 will primarily affect the sale of nonprofit hospitals, it will also affect the activities of conversion foundations that are either tax-exempt section 501(cX3) “public charities” or tax-exempt section 50l(cX4) “social welfare organizations.” This means that a variety of compensation arrangements can expect to receive Internal Revenue Service scrutiny to make certain that they were negotiated at arm’s length and that they are fair and reasonable. Section 4958 will not affect conversion foundations that are tax-exempt section 501(cX3) “private foundations” because “private foundations” have 154 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. been subject to similar rules since 1969. Thus, section 4958 will help to achieve regulatory “parity” between “private foundations,” section 501(cX3) “public charities,” and section 501(cX4) “social welfare” organizations. The effectiveness of the Internal Revenue Service as an industry “watchdog” will depend upon die agency’s financial and manpower budgets and its ability to develop relevant and practical nonprofit excess benefit audit guidelines. Unfortunately, the complexity of the law, the relatively low-level o f tax-exempt organization audits, and the high turnover of experienced agency personnel make it highly unlikely that intense scrutiny of “insider” financial arrangements will occur. A “wait and see” attitude must be adopted. At least one commentator has opined that allowing qui tam actions (i.e., private enforcement proceedings with the possibility of financial reward) could solve the problems stemming from inadequate enforcement activity by the Internal Revenue Service.3 9 4 3 Regulatory Implications from the Hospital Conversion Case Studies Notwithstanding the comprehensiveness of the California Attorney General's hospital conversion regulations and review protocol, there is room for improvement In particular, the hospital conversion files that I reviewed strongly suggest that it would be prudent to implement the following legislative and administrative recommendations to improve the quality of public oversight and participation in the hospital conversion process. 155 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.3.1 Improving Public Access to Hospital Information For this case study, it was difficult to obtain financial information about each hospital on an ex ante basis. Although California’s “Supervision of Trustees and Fundraisers for Charitable Purposes Act”4 0 requires charitable organizations to register and file annual financial reports with the Attorney General (the Registrar of Charitable Trusts), nonprofit hospitals are exempt from the registration and reporting requirements of this A ct4 1 The reason for this exemption is not clear, but it means that nonprofit hospital financial information does not appear in the Attorney General’s charities database (w ww .caao.state.ca.us/charitiesl. although considerable financial and other information does appear in the database of California’s Office of Statewide Health Planning and Development (www.oshDd.cahwnet.aovl. Under existing law, a conversion foundation’s Form 990 or 990-PF would appear in the Attorney General's charities database because there is no applicable statutory registration and reporting exemption. Hospitals provide important services to the residents of their respective communities, and a current issue is whether nonprofit community hospitals are providing a sufficient level of charitable care and other community benefits to justify their existing tax exemptions.4 2 To permit community and consumer groups to monitor die financial health o f nonprofit community hospitals and engage in other oversight activities, all available hospital information should be placed in the public domain. The removal of die current reporting exemption would require every nonprofit community hospital to submit a copy of its Internal Revenue Service Form 990 to the Registrar of Charitable Trusts for inclusion in the Attorney General’s public database. There is no policy reason why die public should not have access to Form 990 information about nonprofit hospitals through the Attorney 156 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. General’s website because, under federal law, every tax-exempt charitable or social welfare organization is already obligated to make its required Internal Revenue Service filings available for public inspection.4 3 Although nonprofit hospitals may be expected to contend that duplicate reporting should not be required, the financial information which appears on Internal Revenue Service Form 990 is different from the information that is reported to die Office of Statewide Health Planning and Development Form 990 is a better tool for promoting public accountability because it requires information about payments to individuals (to help uncover taxable “excess benefit transactions”) and information about possible self- dealing and other potential charitable abuses (e.g., spending too much money on management and too little on charitable activities and programs).4 4 In fact, several years ago representatives o f the Internal Revenue Service and the National Association of Attorneys General redesigned Form 990 to help reveal organizational misfeasance or malfeasance and to promote growing Internet access or “cyber-accountability” 4 5 By posting Form 990 information on the Internet through the Attorney General’s charities database website, interested consumer and community groups will know about compensatory payments to officers and directors, related party transactions, income and asset transfers, expenditures (including amounts paid to professional fundraising organizations), receipts (including contributions from donors), other items of financial interest In short, whether there is a “smoking gun” or only “slight wisps of smoke,” Form 990 will reveal it to the educated reader.4 6 The hospital financial information that is available from California’s Office of Statewide Health Planning and Development is not designed to enable the public to flush out financial improprieties and operating abuses. 157 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A charitable corporation’s governing legal document or “articles of incorporation” is also important because it tells the reader about the organization’s specific charitable purposes. In almost all instances, community and consumer groups expressed concern about die use of the conversion proceeds. In the Good Samaritan, Queen of Angels, and Riverside Community Hospital conversion transactions, the Attorney General placed great weight on certain specificities in die text of the nonprofit hospitals’ articles of incorporation. Unfortunately, these articles are not readily available to the public, although photocopies of a corporation’s articles can be ordered by mail from the California Secretary of State.4 7 To make the Attorney General’s charities database complete and more useful to interested persons, the Attorney General and the Secretary of State should post on the Internet a copy all California nonprofit public benefit corporations’ articles of incorporation. This would enable the public to have access to the corporate articles of both nonprofit hospitals and their conversion foundations and thus permit interested consumer and community groups to better monitor the use of conversion proceeds. There are no serious technological impediments to this recommendation, as the technology that would be required for the Internet posting of corporate articles is no different from die technology that is in current use for the Internet posting of Forms 990 and 990-PF. 4.3.2 Improving Financial Disclosure and Accountability Requirements Under California law, the Attorney General is responsible for supervising more than 80,000 California-based charities that have assets, in the aggregate, of more than $200 billion.4 8 The problem is that the Attorney General does not have sufficient financial 158 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. resources to monitor charitable activities within California or take appropriate enforcement action to remedy fiduciary violations.4 9 Because of resource constraints, typically only die most egregious cases come to the Attorney General’s attention, and then only as a result of complaints by “insiders” (e.g., minority trustees) or, rarely, aggrieved charitable beneficiaries.5 0 In a nutshell, this means that public protection has to be a function of disclosure rather than regulation; i.e., if the Attorney General does not have resources to audit and regulate nonprofits, the public, given access to financial information about nonprofit corporations, will have to make a wise decision and protect itself. An implicit assumption of the Attorney General’s charities database website (www.caao.state ca.us /charitiesi is that with financial information, the public can make a wise decision regarding a charitable organization. A problem, however, is that the statute upon which the website is based contains some glaring exceptions. As previously mentioned, the filing, registration, and reporting provisions of the Supervision of Trustees and Fundraisers for Charitable Purposes Act5 1 do not apply to nonprofit hospitals so that under current law interested persons cannot receive a copy of a nonprofit hospital’s Internal Revenue Service Form 990 from the Attorney General’s website.5 2 However, even if the Attorney General’s website were comprehensive (i.e., the California Legislature were to remove the nonprofit hospital reporting exemption), two other problems would remain. First, although Internal Revenue Service Forms 990 and 990-PF do contain substantial financial and other information, they do not contain audited financial statements. In fact, there is currently no requirement that any tax-exempt organization, regardless of the amount of its revenue or assets, submit audited financial statements to the Attorney General. The accounting and reporting standards of the American Institute of 159 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Certified Public Accountants (AJCPA) and the Financial Accounting Standards Board (FASB) require a balance sheet, a statement of revenue and expenses, and a statement of cash flows. They also require die extensive use of “notes” to disclose litigation claims and loss contingencies, compensation arrangements, related party transactions, and the like. And rather than reporting health services delivered to charity patients as revenue and allowing an offsetting deduction for bad debts, the effect of which is to disguise the true amount of charity care, the AICPA’s reporting guidelines require nonprofit hospitals to disclose in a separate note the amount of patient charges foregone for services and supplies furnished as charity care.3 3 Audited financial statements would enable interested consumer and community groups to better scrutinize the results of a nonprofit hospital’s (or a conversion foundation’s) operating activities. Unlike Form 990 (or 990-PF), audited statements must contain a statement of cash flows (i.e., a statement of cash receipts and cash expenditures). This statement is vital because, under certain circumstances, the accrual method of accounting can present a distorted image of a nonprofit organization’s revenues and expenses.3 4 Moreover, to help donors and others assess a nonprofit organization’s service efforts, audited financial statements are required to disclose management and fund-raising activities separately and provide program specific information about expenditures so that the expenses of one program may not be combined with the expenses of another.3 5 Forms 990 and 990-PF are not as rigid in their disclosure and classification requirements. Finally, audited financial statements are required to show a nonprofit organization’s investments at fair market value rather than historical cost, which means that unrealized gains and losses and hence an organization’s investment performance will be readily apparent to the readers 160 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of its financial statements.5 6 Forms 990 and 990-PF do not require fair market value investment asset disclosure. Second, the Internal Revenue Service’s reporting forms do not tell a complete story because nothing in those forms (or for that matter, a nonprofit’s audited financial statements) tells the reader what the corporation has accomplished during its most recent fiscal year. Under the rules and regulations promulgated by the Securities & Exchange Commission, not only must a public business corporation provide extensive financial information (a balance sheet, comprehensive income statement, and statement of cash flows) to the government and the public, it must also provide extensive management information about the company’s financial condition and results of operations.5 7 Thus, management must identify and discuss weaknesses and unfavorable business trends or uncertainties that could be detrimental to an investor or creditor’s decision or position. Corporate management must adequately disclose all material adverse events and comment upon the company’s financial statements. A comparable requirement would require the management of a nonprofit organization to make similar information disclosures to the public (and the Attorney General) regarding the results of operations, program successes, and program failures in language that is intelligible to a layman. With appropriate penalties to foster full disclosure and minimize or prevent “moral hazard,” 5 8 the integrity of financial and operating information flowing from the nonprofit sector to the philanthropic press, which specializes in gathering, digesting, interpreting, and analyzing financial and operating information for the benefit of the public and government officials, would be significantly enhanced.5 9 161 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Accordingly, to improve the quality of existing information that is in the public domain and raise the level of organizational accountability, the Attorney General should require the submission of audited financial statements and adopt management reporting regulations which are similar to those previously adopted by the Securities & Exchange Commission for public companies in die private sector.6 0 To avoid unnecessarily burdening smaller organizations, these rules could be limited to nonprofit hospitals and conversion foundations (or other nonprofit organizations) with revenues or assets in excess of $10 million. As an alternative to requiring the Attorney General to impose new reporting guidelines. Congress could expand the regulatory disclosure jurisdiction of the Securities & Exchange Commission (SEC) to include large nonprofit organizations (i.e., those with revenues or assets in excess of, say, $10 million) that solicit funds through the channels or instrumentalities of interstate commerce (e.g., mail, telephone, and telegraph). The SEC could be empowered to require every charitable organization with assets or gross revenues exceeding the threshold-reporting amount to submit financial statements (accompanied by the report of an independent accountant) and management’s discussion and analysis of those statements and the results of charitable operations for the current year. This information, once posted on die SEC’s website and public database (www.sec.aov). would enable the public to know which organizations are worthy of support. More important, consumer and community groups would have access to comparative quantitative and qualitative nonprofit health care and other information for regulatory enhancement purposes. 162 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.3.3 Improving Public Participation in the Conversion Process Although for both charitable health care and financial reasons the sale or other transfer of a nonprofit hospital to a “for-profit” hospital corporation is a matter of public interest, under current law the public’s right to participate in the conversion process is extremely limited. After a nonprofit hospital gives written notice to the Attorney General that there is a pending sale or other transfer, the Attorney General has sixty days to evaluate the merits of the proposed transaction and either approve it or reject it6 1 Within that sixty day period, the Attorney General is required to conduct “one or more public meetings. . . to hear comments from interested parties.”6 2 The public’s opportunity to meet and comment on the proposed conversion transaction is limited because the current statute requires that all public comments be presented to the Attorney General at a “public meeting.” There is nothing in the statute or the Attorney General’s review protocol that allows the public to make written submissions to the Attorney General, and nothing that requires the Attorney General to give the public’s written submissions due consideration. Administrative procedure acts typically provide interested persons an opportunity to participate in a government agency’s decision making through “submission of written data, views, or arguments with or without opportunity for oral presentation.” 6 3 Moreover, a government agency is generally obligated to consider third-party submissions and give reasons for their acceptance or rejection.6 4 Under administrative procedure acts, written submissions typically precede oral presentations so that the participants’ comments will be focused and relevant to the matter that is being heard. In the absence of prior written submissions, a “public meeting” may contain little or no substance. For example, representatives of Consumers Union attended 163 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the mandatory public meetings for Riverside Community Hospital and Queen of Angels, the two transactions that closed after 1996 and thus were subject to the statutory “public meeting” requirement In die case o f Riverside Community Hospital, the public transaction file indicates that Julio Mateo, an attorney for Consumers Union, used the Riverside public meeting, held on April 2, 1997, as a forum to explain why Consumers Union had been studying conversion transactions for more than twelve years and why die public should be interested in conversion transactions. Mr. Mateo’s public remarks were general in nature; if he made any substantive remarks pertinent to the actual Riverside transaction, the public file does not so indicate. In theory, the Attorney General is the protector of the public’s interest in hospital conversions and thus public participation is not required. However, this may not be a valid assumption because there is no one “consumer” interest group. Experience shows that different community and consumer groups have different expectations and policy agendas. Effective public participation requires the Attorney General to receive thoughtful and considered views from interested parties, however diverse those views may be. Although a “public meeting” is an administratively simple solution to balancing die costs and benefits o f administrative due process, it may amount to an opportunity for public claptrap and nothing more. Accordingly, the Attorney General should give interested parties the opportunity to make submissions of their written data, views, and arguments about a proposed conversion transaction, and, if appropriate, a “public meeting” should be held so that relevant oral presentations can be made. The Attorney General should be required to appropriately consider the submissions of interested parties, and he should be required to place a concise 164 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. statement of his findings in the public transaction file (or post his findings on the Internet) for additional public comment.4 5 The public has a right to present its views concerning the merits of a particular transaction, and the public has a right to expect that the Attorney General has considered them. As previously mentioned, the Attorney General has already begun to post notices of nonprofit hospital transactions on his website (www.caaQ.state.ca.us/charities/notices.html. together with pertinent transaction documents. The Attorney General should post information about a formal submission process so that interested persons can download the transactional documents, prepare their submissions of written data, views, and arguments, submit them to the Attorney General for his consideration, and then, if necessary, participate in a ‘ 'public meeting.” To facilitate thoughtfulness and preparation, submissions should precede any public meeting and be a prerequisite to any oral presentation of views at a “public meeting.” The actual public meeting would then be of greater benefit to all interested parties, including the Attorney General. 4.3.4 The Attorney General*s Use o f Appraisals The Attorney General’s hospital conversion review protocol emphasizes the importance of business valuation appraisals and the need for professional assistance by investment bankers, accountants, and valuation analysts.6 6 Appraisals are now being posted on the Internet through the Attorney General’s charities database website where, presumably, they will be subjected to public scrutiny by interested consumer and community groups along with other transaction documents. Unfortunately, public posting of appraisal and other transactional information does not relieve the Attorney General of 165 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. his statutory review duties. What seems to be missing is the Attorney General’s in-house ability to understand and criticize the appraisal or valuation reports. Lacking adequate staff with expert knowledge in business enterprise valuations, die Attorney General is overly dependent upon the services of outside experts to criticize other experts. Of course, the Internet posting of appraisal documents may provide interested parties the opportunity to present important insights to the Attorney General—insights that might otherwise be unavailable. None of the valuation reports I was permitted to review followed an appropriate or standard valuation format; e.g., the Uniform Standards o f Professional Appraisal Practice, promulgated by the Appraisal Foundation, Washington, D.C.6 7 A business valuation report should contain appropriate introductory materials (e.g., cover letter, date of valuation, and statement of disinterest), information about the standard of value used (e.g., the definition of “fair market value” for a particular purpose), and a statement of assumptions and limiting conditions. Moreover, a report should contain a comprehensive financial review (with at least five-years of financial statements, preferably audited), valuation analyses (using the discounted cash flow, comparable transactions, and comparable companies approaches, together with pertinent supporting schedules), and a summary of valuation conclusions. Most important, a business valuation report should contain information about the appraiser’s credentials. Core competency in business valuation is offered by several organizations, including die American Society of Appraisers, the Institute of Business Appraisers, the National Association of Certified Valuation Analysts, and the American Institute of Certified Public Accountants. None of the valuation materials or reports that I 166 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. reviewed indicated whether the author of the report was properly credentialed to perform the engagement in question. The valuation reports I reviewed were deficient in many o f the areas mentioned above. For example: • Good Samaritan Health System’s valuation report was prepared by Shattuck Hammond Partners. Although the source o f some of the financial information is not clear, with the exception of some unintelligible calculations and abbreviated valuation conclusions, the report appears to have been reasonably well prepared. The report, however, does not contain a statement o f the appraiser’s qualifications. • Queen of Angel’s valuation report was prepared by Arthur Andersen’s Boston office. Missing from the otherwise meticulously prepared report are financial statements (prepared by Coopers & Lybrand) and a statement of the appraiser’s qualifications. • Riverside Community Hospital’s valuation report was prepared by its independent accountants, Ernst & Young. Unfortunately, there appears to be no evidence of any statement of disinterest by Ernst & Young in the outcome of its hospital valuation. Moreover, financial statements, pertinent cash flow details, and information about comparable transactions and comparable companies were either missing or unavailable. 167 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The Attorney General should have rejected these and other valuation materials, not because their opinions of value were necessarily wrong—in all cases the prices were within reasonable valuation ranges—but because die proffered reports were incomplete and not prepared by credentialed business valuation appraisers in accordance with standard business valuation practices and procedures. To properly exercise his review responsibilities, the Attorney General should have access to government-trained valuation specialists who can assist the lawyers in his office to read and understand complex business valuation reports. The Internal Revenue Service, for example, maintains a staff of trained valuation “engineers” whose task it is to determine questions of “fair market value” for Internal Revenue Code enforcement purposes. The Franchise Tax Board employs similar personnel for the benefit of its field agents and auditors. Perhaps the Attorney General could “borrow” qualified Franchise Tax Board valuation personnel to educate and assist the lawyers in his office. 4.3.5 Use o f Conversion Proceeds In several cases, especially Good Samaritan and Queen of Angels, die Attorney General used his power and influence to usurp die ability of the conversion foundation’ s board o f directors to decide the proper use of hospital conversion proceeds, so much so that the directors of Good Samaritan’s conversion foundation asked California Senator Kenneth L. Maddy to intercede on their behalf. Senator Maddy’s proposed legislation would have given the directors of Good Samaritan’s conversion foundation die right to use the hospital’s conversion proceeds for a broad range of community, albeit health-related, 168 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. purposes. The specificity of use that die Attorney General imposed upon Good Samaritan and Queen o f Angels (less so in the matter of Riverside Community Hospital and Centinela Hospital) is contrary to the generally accepted notion that the directors of a nonprofit charitable organization should be permitted to exercise their independent judgment and discretion when it comes to matters of spending. The Attorney General’s role is to remedy abuses in the management of charitable organizations; it is not to “participate” in their “contractual undertakings” or serve as their “super administrator.” “ California’s hospital conversion legislation requires that the proposed use of the proceeds from the conversion transaction be “consistent with the charitable trust” that governed the activities of the selling hospital.6 9 The California Supreme Court has stated that the articles of a charitable corporation must be “read as a whole” and that, in appropriate cases, the courts must also consider how the corporation actually conducted its charitable activities.7 0 Thus, the purposes of a charitable corporation may be established by both its articles and its actual operating history, including its required “community benefits plan.” 7 1 The governing documents of the hospitals I reviewed permit broad health care related activities, and the doctrine of cy pres does not require great specificity.7 2 For example, the articles of incorporation of Good Samaritan permit the corporation “to participate in any activity. . . designed to promote the general health of the community,” 7 3 and the articles of Queen of Angels refer to “the care and treatment of die sick, afflicted and aged.” 7 4 Yet, the spending provisions in the Attorney General’s documents for the conversion foundations are extremely detailed and they may be tantamount to placing fiscal handcuffs on the directors. 169 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The detailed spending provisions exist because consumer advocacy groups, especially Consumers Union, argued before the Attorney General that if the directors of the conversion foundations were given See rein to use the conversion proceeds as they saw fit, indigent patients might not receive adequate hospital care. However, Consumers Union presented no evidence that this would occur. The problem now is that the respective directors of the Good Samaritan and Queen of Angels conversion foundations (QueensCare and The Health Trust) may not consider changing community needs without first obtaining administrative and judicial approval, a complex process. The Attorney General’s level o f micro-management in the spending process is misplaced. The board of directors, not the Attorney General, is better suited to consulting with community and consumer groups to assess the needs within a community and develop an appropriate spending plan. To take into account the wishes of community and consumer groups, California’s hospital conversion law should provide for mandatory consulting or advisory committees to assist a conversion foundation’s board of directors. For example, a statute could provide:7 5 ■ » Before spending the proceeds from the sale or other transfer of a health facility to which this article is applicable, the board of directors shall consult with representatives of health facility associations, physician organizations, consumer groups, and community groups to prepare an appropriate spending plan. The spending plan shall consider charitable health care and community health benefits. After consultation, the spending decision shall be the responsibility of the board. 170 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A provision of this kind would eliminate die Attorney General’s micro-management, provide flexibility, permit interested groups to present their views to a conversion foundation’s board of directors, but reserve die actual spending decision to die conversion foundation’s board of directors. Accordingly, the California Legislature should amend the hospital conversion law to permit a conversion foundation’s board of directors to develop, implement, and audit spending plans with the cooperation of a mandatory consumer and community group advisory committee. The conversion foundation’s board of directors could be given the right to select members of the mandatory advisory committee from an Attorney General- approved list of health care, consumer, and community groups or organizations. This approach would remove the Attorney General from his position as the creator of a conversion foundation’s spending plan and actually return the design of the plan to the foundation’s directors and interested parties within the affected community. Consumers Union, for example, believes that “community advisory committees” should be used not only to provide a foundation’s board with a critical assessment of the foundation’s operating performance, but also to provide a foundation’ s board with recommendations for new board members.7 6 An advisory committee could certainly serve a dual purpose. 4.4 Public Policy Extensions of Existing Law The stakeholders in hospital conversions include potential donors, management, patients (including the medically indigent), potential or actual charitable beneficiaries who 171 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. have health care needs, and, of course, government Different policy perspectives and approaches exist7 7 For example, some groups favor regulatory-type legislation of the kind exemplified by California’s hospital conversion law, which is essentially adjudicatory in nature because the Attorney General is obligated to engage in fact-finding and make a final and conclusive determination as to the merits of a particular conversion transaction. Other groups favor disclosure-type legislation to combat information asymmetries, prevent externalities and corruption, and enable the public (as both consumers and donors) to make intelligent decisions regarding whether or not to patronize or support a particular nonprofit organization. Unfortunately, there is no perfect answer or solution to the problem of government or market failures, only broad generic policies.7 1 One thing is clear The tides of reform are now sweeping across the nonprofit sector. Thus, a current debate in the nonprofit sector is whether the “watchful eye” tradition (i.e., the “sunshine of public scrutiny” should be used to improve nonprofit management and performance and help weed out inefficiency) or the “liberation management” tradition (i.e., nonprofit organizations need to be entrepreneurial and largely exempt from government regulation) should receive support7 9 Because nonprofit management is a repository for much private information and many activities of nonprofit organizations tend to be unobservable, adverse selection and moral hazard problems do exist8 0 True, the business sector has similar problems, but mandatory information disclosure rules and statutes enabling derivative suits allow stockholders to protect their financial interests. Traditionally, the nonprofit sector has remained more in the shadows than in the sunshine of public scrutiny. 172 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In this section, I present some normative bat controversial public policy recommendations to improve the hospital conversion process. The recommendations are not necessarily limited to nonprofit hospitals and conversion foundations. In fact, they may be applicable to many nonprofit public benefit organizations. I mention them for their possible prescient value and to suggest paths for future inquiry and scholarship. 4.4.1 Bringing Sunshine to the Board In California, as well as most otter states, the board o f directors of a nonprofit public benefit (or charitable) corporation is responsible for the corporation’s activities and affairs.1 1 This means that the board of directors of a nonprofit community hospital is ultimately responsible for hospital operations, hospital financial management, and the quality of patient care. It also means that the board can decide whether to expand or contract hospital operations, merge with another charitable hospital organization, or, in the case of acute financial distress, even sell the facility and exit from the hospital industry altogether. Similarly, after a nonprofit community hospital is sold the board of directors of the conversion foundation is responsible for managing the sales proceeds and spending the income or principal (or both) for Attorney General-approved charitable purposes. Although a nonprofit charitable organization’s activities are for public benefit, the deliberations and decisions of a charitable corporation’s board o f directors are private. In other words, there is effectively no way for the public to either acquire information about board members or board activities or convey information to board members that might help to improve the board’s collective decision-making. Two incidents serve to illustrate the 173 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. problems that can be caused by board privacy and the lack of public observation and participation. The first incident is the aborted sale of Sharp Memorial Hospital to Columbia/HCA Healthcare Corp. In 1996, the California Attorney General objected to the San Diego Hospital Association’s decision to sell one of its non-profit hospitals (Sharp Memorial Hospital) to Columbia/HCA for approximately $400 million on the grounds that the hospital’s articles of incorporation required corporate assets to be used solely for the purpose of acquiring and operating a non-profit charitable hospital and medical center in the City of San Diego. The Attorney General stated that any sale or transfer of assets would constitute a breach of trust for which the directors would be personally liable. However, the real reason for the Attorney General’s objection was the apparent lack of financial necessity for any sale coupled with evidence of significant under-valuation: the Attorney General’s investigation revealed that Sharp’s board of directors had summarily rejected offers that would have yielded $100 to $200 million more than Columbia/HCA’s offer for reasons that could not be explained to the Attorney General’s satisfaction. Rather than judicially contest the Attorney General’s belief that the hospital should be retained and not sold, in 1997 the board and Columbia/HCA decided to terminate their discussions and any sale agreements.*2 The Sharp Memorial Hospital incident is important because, one year earlier, the board of directors retained an outside health care consultant, Shattuck Hammond Partners of San Francisco, a health care consulting affiliate of PriceWaterhouseCoopers, to evaluate the hospital’s long-term health care strategies and goals. It was Shattuck Hammond who suggested a sale to a “for-profit’ ’ organization and who helped the board find interested 174 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. “suitors.” Yet, die board did not engage in any public debate or discussion about the hospital's future, nor did die board solicit the views of any community or business leaders regarding a proposed sale. The Attorney General’s office found it difficult to understand how die board could have thoroughly considered all realistic alternatives to a sale, including a merger or a strategic alliance with another nonprofit entity, without public scrutiny and debate or, at the very least, full disclosure of die board’s operating concerns to, and frank conversations with, leading community and business leaders.8 3 In short, the policies behind the notice and disclosure provisions of California’s hospital conversion law worked to protect the community’s interest in its local nonprofit hospital. Second, and more recently, in 1999, the New York Attorney General intervened in the proposed sale o f the Manhattan Eye, Ear & Throat Hospital’s real estate to a downtown developer after an article about the proposed sale appeared in the New York Times. It appears that the nonprofit hospital’s board, which was essentially self-perpetuating, had agreed with a consultant’s report, also prepared by Shattuck Hammond Partners, that the hospital had no value independent of its real estate, which was worth between $46 and $55 million. Siding with the Attorney General, the trial court blocked the proposed sales transaction because the evidence showed that other major New York City medical centers were willing to invest capital to operate the hospital and make it financially viable. For some inexplicable reason the board failed to consider these overtures and thus it was willing to monetize the hospital’s assets and put them to a different charitable use at die public’s expense. Even more troubling were the revelations during the trial that the board as a whole failed to consider strategies to preserve the hospital, some members of the board might not have fully understood the ramifications of the proposed transaction, and Shattuck 175 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hammond bad a financial interest in the sales transaction because o f a 1 percent negotiated transaction fee (i.e., at a minimum, an additional $460,000 if the sale closed).8 4 The Sharp Memorial and Manhattan Eye hospital incidents suggest a primary public policy recommendation, namely that it is prudent to extend California’s “sunshine in government” legislation (the Ralph M. Brown Act8 3 ) to all decision-making activities of nonprofit public benefit hospital corporations. California’s Brown Act, which was adopted in 1953 and extensively revised in 1961, governs meetings conducted by local legislative bodies such as county boards of supervisor, city councils, school boards, and certain corporations.8 6 Under the Act, the public must be given adequate notice of a particular meeting’s time, place, and agenda. More important, unless matters are subject to a special “closed meeting” exception, all discussion and debate is required to be open to die public, and interested citizens are entitled to present testimony on items o f interest to the public that are within the agency’s subject matter jurisdiction. The Act’s premises are that “public knowledge of the considerations upon which governmental action is based is essential to the democratic process” 8 7 and that open deliberation combined with public scrutiny—the element of “sunshine”—will inevitable lead to better decision-making and minimize the possibility of opportunistic decision-making and corruption. The agenda posting and public testimony requirements lie at the heart of the Brown Act At least 72 hours before a regular meeting, a local legislative body that is subject to the Brown Act must post an agenda stating the general description of each item of business to be conducted at the meeting. The general rule is that no action may be taken on any matter or issue unless the matter or issue appears on the posted agenda. The most important provision is the provision for public testimony; die agenda for a regular meeting 176 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of a local legislative body roust provide an opportunity for members of the public to directly address the legislative body on any matter of interest to die public. The only requirement is that the matter be within the legislative body’s subject matter jurisdiction; the matter itself need not even appear on a particular agenda posting.8 * The Brown Act is already applicable to two classes o f “private corporations,” whether “for-profit” or “non-profit” in character.8 9 First, the Act is applicable to any “private corporation” that is created by an “elected legislative body” in order to exercise lawfully delegable public authority; e.g., a nonprofit public benefit corporation created by a local public agency to construct or operate a public works project Second, the Act is applicable to any “private corporation” that receives public funds from a local public agency, but only if a member of the local public agency is also a “full voting member” of the corporation’s board of directors. In die first, case there is the exercise of some measure of government power by a private corporation; in the second, there is the receipt of local public agency funds by a private corporation that has a board member from that same local public agency. Although nothing in the statute literally states that the mere receipt of public funds by a nonprofit public benefit corporation triggers the “open meeting” requirements of the Brown Act, there is at least one controversial legal opinion from the California Attorney General which suggests the result should be otherwise. In 1987, the Attorney General opined that a nonprofit public benefit corporation, which was formed to acquire land and construct a public coliseum and stadium in the City of Oakland, County of Alameda for sporting events, was subject to the open meeting requirements of the Brown A ct9 0 What is controversial about that opinion is that although die nonprofit corporation had been formed 177 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. to construct and operate a public works project, there was no “local public agency” involvement because the organizers of Oakland-Alameda Coliseum, Inc. were six private citizens. In effect, the Attorney General ruled that die decision to privatize the ownership of a public coliseum was tantamount to allowing the board of directors of a California nonprofit corporation to exercise governmental powers and hence the Act’s “sunshine” purpose would be frustrated by the absence of the possibility of public participation and public scrutiny.9 1 In the case of a nonprofit hospital corporation that relies, in part, upon public funds (tax expenditures), the privatization and delegation argument would appear to be much stronger. Some citizens groups have attempted to apply the Brown Act’s open meeting requirements to nonprofit public benefit hospital corporations but with mixed success in the California courts.9 2 Because charitable hospitals do operate with public funds, the legislature could amend the Brown Act to subject to its open meeting requirements the regular and annual meetings of the boards of nonprofit public benefit hospitals and other health care corporations. If the Brown Act were expressly applicable to charitable hospitals and other charitable health care corporations, most board meetings would be open to the public and interested citizens would have the opportunity to express their opinions on issues under board consideration. The board o f directors may reasonably limit the time available for public discussion and take appropriate measures to avoid die willful disruption of any meeting.9 3 The principle objections to extending the Brown Act to nonprofit public benefit hospitals and other health facilities are two-fold. First, there is the objection that any extension would improperly interfere with a vested “corporate right” of internal self- 1 7 8 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. governance. Second, there is die objection that extending the Brown Act to nonprofit public benefit hospital corporations would make it difficult to draw a bright line and thus place the legislature on a slippery slope: why not extend the Brown Act to all nonprofit public benefit corporations, including colleges and universities? 9 4 It is easy to answer the first objection: in California, and in most other states, there is nothing sacred in the law of corporations as it pertains to a state’s power to change the provisions of a corporation's charter (or “contract” with die legislature). In the famous Dartmouth College case,9 3 Chief Justice John Marshall held that New Hampshire could not unilaterally modify a private institution’s state charter to place the college under public control. Such action, stated Marshall, would violate the contract clause of the Federal Constitution.9 6 Justice Story, however, in his concurring opinion, observed that the contract clause would not be violated by a state legislature’s express retention of a power of charter modification. In California, the state constitution expressly allows the California Legislature to alter or amend all laws concerning corporations “from time to time.” 9 7 Because of this constitutional provision, when a California corporation is framed, its organizers have no vested legal right to demand that the state refrain from changing the law of corporations, including die law of corporate governance.9 8 The answer to the second objection is pragmatic: in the law, many “slippery slope” claims are widely exaggerated.9 9 There is no universal “nonprofit public benefit corporation,” just as there is no universal “general business corporations.” A corporation’s purposes and the attributes of its stakeholders do matter. For example, educational institutions can qualify for Internal Revenue Code § 501(cX3) tax-exempt status. These charitable organizations tend to have well-defined and well-organized stakeholders 179 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (principally faculty and students) that can be expected to monitor die activities of the organization’s management, even if “board meetings” are private, or otherwise press their legal claims in the event of a legitimate grievance. What is most important is that die law of contract applies to an educational institution’s relations with its faculty and students so that both groups have standing to compel the adjudication of their disparate legal claims.1 0 0 Even though it has been suggested that state “sunshine” laws should be made applicable to charitable educational corporations,1 0 1 there appears to be no practical need because faculty and student groups tend to possess adequate bargaining power to deal with their needs. Those who visit charitable organizations that supply health care are in a more precarious position. Indigent patients who may be charitable “beneficiaries” have little or no standing to press any legal claims and little or no right to petition for the dispensation of charitable benefits. Moreover, they do not belong to bargaining organizations such as student unions or faculty associations that are capable of exerting influence on their behalf. The disparities in health, income, bargaining power, and education strongly indicate that a line can be drawn; i.e., extending the Brown Act to charitable health care organizations, including conversion foundations, does not mean “the camel's nose is in the tent” It only means that charitable corporations have different activities and stakeholders (including potential charitable beneficiaries) who have different personal attributes. It is the task of the legislature to discern these differences when it legislates. Otherwise, the directors of a nonprofit public benefit corporation that operates a tax-exempt museum should not be permitted to sell the museum’s assets to a “for-profit” entity and use the sales proceeds for some other charitable purpose without incurring the same level of public, administrative, and judicial scrutiny which is currently applicable to hospitals and other health facilities. 180 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. After all, the museum's directors could undervalue die collection and unjustly enrich someone at the public’s expense.1 0 2 Of course, in die event of a proposed sale of a hospital facility, public scrutiny of board members’ deliberations and actions may be insufficient to assure board consideration of all relevant factors. In the end, the decision to sell or retain a nonprofit hospital rests with the members of the hospital’s board and not the vox populi. Nevertheless, public presence in the boardroom—the element of “sunshine"— should lead to public questions and two-sided information flows1 0 3 that can help board members obtain important information and thus prevent premature decision-making (e.g., the situations described in the Sharp Memorial Hospital and Manhattan Eye, Ear & Throat Hospital incidents) from occurring. The open meeting requirement is also important for charitable organizations that have the responsibility to manage and spend conversion proceeds. The Attorney General’s carefully crafted spending plans for conversion proceeds may not be optimally implemented, especially if citizen-beneficiary groups do not have the opportunity to present their concerns to the organization’s board of directors. The best compliance tool to assure the optimal administration of the Attorney General’s spending plans may be public awareness due to revised “sunshine” legislation. Public awareness will allow public interest groups and community health care organizers to exert pressure upon board members and, if necessary, request the Attorney General to bring a civil action to require the charitable organization’s board of directors to comply with the terms and conditions of the hospital’s sale, including the provisions governing the use of the hospital’s sales proceeds. 181 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The principal objection to applying “sunshine legislation" to nonprofit public benefit corporations is that the nonprofit world will never be the same. Fortunately, that is not a valid objection. It is precisely because nonprofit public benefit corporations have no “owners" to whom management is accountable that a possibility of state intervention must exist in order to prevent or minimize the potential misappropriation of charitable assets. Hansmann’s points are well made and they need to be emphasized: the beneficiaries of nonprofit charitable corporations tend to be in a poor position to determine either the quality or the quantity o f the corporation’s charitable benefits or distributions, and the donors are usually just as ignorant1 0 4 Thus, in many cases there is no one who can effectively monitor the performance of the charitable corporation’s managers. In democratic theory, accountability to the electorate is a critical requirement which is why the Ralph M. Brown Act and others like it exist Since the directors of nonprofit public benefit corporations are non-government actors who are charged with exercising administrative authority over important quasi-governmental assets,1 0 3 at the minimum there should be the possibility o f public oversight so that, if necessary, appropriate government officials can intervene in the corporation’s affairs and hold the directors properly accountable.1 0 6 Accordingly, to improve the quality of corporate governance I recommend that the Ralph M. Brown Act be extended to all nonprofit public benefit corporations having either revenues or assets of $10 million or more that “operate or control" a “health facility." 1 0 7 This arbitrary floor will spare small hospital and health care organizations the expense of compliance and yet assure the public that it will have the opportunity to confront the directors of large health care organizations.1 0 8 Moreover, California’s hospital conversion 182 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. statutes should be amended to give the Attorney General discretion to require that a conversion foundation adhere to the provisions of the Brown Act as a condition to the Attorney General’s transactional consent Thus, small conversion foundations such as the Pacific Hospital of Long Beach Charitable Trust would not have to be burdened but the larger conversion foundations would be subject to some modicum of public scrutiny. 4.4.2 Placing Public Members on the Board The Sharp Memorial and Manhattan Eye Hospital incidents also illustrate a common problem: directors of charitable corporations are prone to various pathologies. They may not have sufficient knowledge or expertise to make the important financing, investment, and operating decisions that are required of them, or their decision-making abilities may be impaired due to cronyism, nepotism, or even illness. For example, in the 1940s, the George Pepperdine Foundation (which funded what is now Pepperdine University) lost $3 million as the result of director mismanagement The appellate court speculated that Mr. Pepperdine, who dominated the board and who concealed the losses from other board members, might have experienced “a deterioration of his mental processes with advancing years.” 1 0 9 The other board members were subservient to Mr. Pepperdine’s wishes and they rarely, if ever, questioned his judgment1 1 0 Under California law, nonprofit public benefit corporations are required to have at least one director,1 1 1 and unless the nonprofit corporation’s articles o f incorporation or bylaws provide otherwise, the size of the board (i.e., the actual number of board members) and qualifications for board membership are entirely matters of board discretion: there are no statutory standards or competency requirements for nonprofit public benefit corporation 183 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. board members. Moreover, since changes in board size and composition are likely to occur, if at all, gradually over time and it is the existing or outgoing directors who typically select new board members, new members are likely to reflect the collective attitudes and values (die entrenched “business culture”) of die board to which they have been recently appointed. In other words, “when people set to die task of selecting their successors, the successor tends to resemble the chooser.” 1 1 2 Thus, there can be no assurance that “self selected” individual board members will possess the necessary managerial skills to perform their duties in a diligent and competent manner, and no assurance that a dissatisfied minority would attempt to block majority action that might be detrimental to the public’s welfare. California’s response to Pepperdine and other board pathology problems was to allow a breach of trust to be remedied by any corporate officer or director, in addition to the Attorney General."3 But this remedy would seem to be inadequate because directors tend to be protective of their own kind (the prospect of cronyism) and litigation tends to occur only after irreparable harm has occurred. To help promote and maintain a high degree of managerial professionalism, the law should require one or more “public members” to serve on the boards of nonprofit hospitals and conversion foundations. Two principal methods could be used to place a “public member” on the board of a nonprofit corporation that operates or controls a “health facility” or is responsible for managing the assets and activities of a conversion foundation. First, the California Corporations Code could be amended to allow the existing directors to select at least one “public member” director from an Attorney General-approved list of organizations, including a health facility association, a physician organization, a consumer group, or a 184 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. community group. Second, the Code could be amended to require that at least one “public member” director be appointed by an elected government official. The first solution leaves the selection of the “public member” to the directors of the existing health care corporation or conversion foundation. The Attorney General’s list of approved organizations might include Consumers Union, the California Nurses Association, the California Medical Association, die American Association o f Retired Persons, and other recognized groups that have been active in hospital conversions in California. The advantage to this solution is that it would be relatively easy to implement, and only minor changes to the Nonprofit Public Benefit Corporation Law would be required for completeness and consistency (e.g., the legislature might require nonprofit “health facilities” to have a minimum number of directors, including one or more “public member” directors). The second solution is already in use in California by professional regulatory boards; e.g., the Board of Dental Examiners, the California Medical Board, and the California Board of Accountancy.1 1 4 For example, collectively the Governor, the Senate Rules Committee, and the Speaker of the Assembly appoint all the members of the California Board of Accountancy, including the “public members.” 1 1 5 This selection policy suggests that the required public members of a nonprofit “health facility” corporation or a conversion foundation could be appointed by an elected official. For example, a power of appointment could be given to the California Attorney General, the board of supervisors of the county in which the facility or principal place of business is located, or the elected mayor or city council of the city in which the facility or principal place of business is located. 185 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The principal objection to the “public member” board requirement is one of corporate autonomy and intrusion: a nonprofit public benefit corporation is a “private corporation” that happens to serve a public or charitable purpose; it is not a “public” agency or public corporation.1 1 6 This objection is not easy to dismiss because, unlike the previous “sunshine” proposal, which would not directly affect a nonprofit public benefit corporation’s internal governance, this proposal would change the decision-making dynamics. Nevertheless, under its “police power” the California Legislature could determine that health facilities and their related conversion foundations are of such paramount importance to public health or welfare that a public intrusion into the governance process of a “private corporation” is both warranted and appropriate.1 1 7 Accordingly, California could require that large nonprofit hospitals and conversion foundations (i.e., those with assets or gross revenues of more than S10 million) have, say, at least seven directors, two of which must be “public member” directors. The “public members” could serve for a term of, say, three years and be eligible for reappointment A secondary objection to a “public member” board requirement is that the cost of identifying and installing public members may outweigh the benefits. For example, no one really knows whether the public members now sitting on California’s professional regulatory boards are able to effectively contribute to the regulatory process. Moreover, an uninformed, inexperienced, or otherwise unqualified voting public member of the board of a nonprofit hospital or conversion foundation may be worse than no public member. Consequently, in the long-run educating existing board members about their fiduciary obligations may be the more prudent course of action. 186 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.4.3 Improving Regulatory Oversight o f Charitable Organizations In the United States, it is the states’ attorneys general who have jurisdiction to supervise charitable organizations. In California, the supervision o f charitable organizations has to compete with numerous other programs for financial and personnel resources: the California Attorney General is responsible for consumer protection, criminal justice (including crime prevention), maintaining criminal statistics, enforcing California’s civil rights and firearms laws, state ballot initiatives, and providing legal opinions to state and local government officials."8 Financial resources notwithstanding, in California charities usually receive short shrift because criminal and other civil matters tend to consume the Attorney General’s human resources.1 1 9 The supervision of nonprofit hospitals and other charitable organizations, including those responsible for managing and spending hospital conversion proceeds, would be substantially enhanced if the California Legislature were to enact measures similar to those in effect in England and Wales under the Charities Act 1993. That Act provides for a body of government officials, known as “charity commissioners,’ ' who have broad oversight, investigative, and remedial powers to investigate charities and check abuses. If California were to adopt the broad principals of that Act, California’s “charity commissioners’ ’ would have the statutory authority to: • Serve as the official custodian for the legal documents of all nonprofit public benefit corporations in California and maintain an appropriate database. 18 7 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. • Receive public testimony concerning charitable activities and investigate the affairs of any charitable organization. • Appoint, discharge, or remove the trustees, directors, or officers of any charitable organization. • Give advice to trustees and directors concerning the administration of their respective charitable organizations. • Establish a “scheme,” policies, or operating plan for the effective administration of a charitable organization. • Allow charitable organizations to vary their charitable purposes without the necessity of judicial intervention. None of the above represents a radical departure from existing law or public policy because the Attorney General, as parens patriae, already has broad common law and statutory powers to intervene in a charitable organization’s affairs. The problem is that he does not have the resources to be an active regulator. What is new, perhaps radical, is the notion that investigative and supervisory powers should be placed in the hands of a body of “charity commissioners’ ’ who, having been appointed by the governor, would be independent of the Attorney General but share concurrent jurisdiction. California already has something similar for consumer protection. The Department of Consumer Affairs, the director of which is appointed by the governor, possesses broad powers to regulate businesses and professions to protect consumer 188 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. interests.1 2 0 The Director of Consumer Affairs is required to receive complaints from consumers, investigate illegal business and professional practices, and, if necessary, seek the assistance or intervention of the Attorney General with whom die Director shares concurrent jurisdiction. The law expressly permits either the Director or die Attorney General to commence legal proceedings for consumer protection purposes.1 2 1 Given the size of California's charitable sector and the needs of potential donors and charitable beneficiaries, a stronger regulatory framework for donor-beneficiary protection is both desirable and necessary. The imposition of reasonable filing and registration fees could be used to fund a budget for the proposed “California Board of Charity Commissioners,” which would then assume responsibility for maintaining die searchable charities’ database and expanding its coverage to include appropriate legal documents (e.g., articles of incorporation). The Commissioners could then hire appropriate personnel to respond to public complaints, audit Forms 990 and 990-PF, attend board meetings as observers, and perform other tasks. It would be the “continuing duty” of the Charity Commissioners to “discern patterns of complaints” and keep the Attorney General properly advised so that he could undertake appropriate legal action.1 2 2 4.4.4 Providing Limited Standing to Charitable Beneficiaries Although charitable organizations, whether in the legal form o f a trust or a nonprofit public benefit corporation, exist for the benefit of a class of charitable beneficiaries, at common law the actual or potential beneficiaries o f a charitable organization do not have standing to bring an action to remedy a breach of charitable trust The reason for this rule is that charitable organizations tend to have numerous and 189 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. sometimes shifting beneficiaries so that to permit an actual or potential beneficiary to bring a suit to enforce or protect an alleged charitable entitlement would be to sanction possibly vexatious litigation. Thus, at common law a suit to enforce or protect a charitable trust could be brought by charitable beneficiaries only if the charitable trust was created for the members of a small class of easily identifiable persons; e.g., the poor members of a particular church.1 2 3 Where the class of actual or potential beneficiaries was large and thus difficult to identify, the common law gave the attorney general exclusive jurisdiction to enforce and protect first charitable trusts and then charitable corporations.1 2 4 California’s current statute follows the common law rale in that it does not allow for beneficiary enforcement of the terms of a nonprofit public benefit corporation’s articles of incorporation. Unless an aggrieved actual or potential beneficiary can convince a nonprofit public benefit corporation’s director, officer, or the Attorney General that legal action is appropriate to enjoin, correct, or otherwise remedy a breach of charitable trust, no suit is possible.1 2 3 The result is that charitable beneficiaries of a nonprofit public benefit corporation have no assurance that their grievances or claims against a public benefit corporation will be heard. In other words, an individual who is or claims to be a member of the corporation’s class of beneficiaries may have a right or legal entitlement to certain benefits that are offered by the corporation but no effective legal remedy to obtain them. It may be ironic that potential or actual beneficiaries of government programs are entitled to due process procedural protections but potential or actual beneficiaries of nonprofit public benefit corporations, many of which are directly or indirectly funded by the government, are not Thus, the government cannot deny or terminate public assistance or welfare payments without procedural due process protections,1 2 6 but, unless the Attorney 190 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. General or a corporate director or officer chooses to intervene, a public benefit corporation may ignore the claims of an actual or potential beneficiary or a class of actual or potential beneficiaries with impunity. The dilemma, of course, is how to make public benefit corporations more responsive to the requests or claims of actual or potential beneficiaries without fomenting unreasonable litigation. A practical public policy solution would be to allow collective beneficiary action to enforce the provisions of the articles of incorporation of a charitable corporation or a charitable trust agreement For example, under California law no individual has the legal right to file a complaint with the Public Utilities Commission regarding the reasonableness of utility rates established by die Commission, but if a complaint is filed by twenty-five or more “actual or prospective consumers” of a particular utility’s service, the Commission must hear that complaint1 2 7 This suggests that a reasonable accommodation would be to require the Attorney General to investigate the allegations contained in a written complaint signed by twenty-five or more “actual or potential” charitable beneficiaries and to allow a member of that group to institute appropriate legal proceedings on the group’s behalf.1 2 * The principal drawback to beneficiary governance is that information concerning a charitable organization’s general and specific purposes is frequently unavailable to the public so that actual or potential charitable beneficiaries can be ignorant of their expectations or entitlements. As I have previously mentioned, the Attorney General’s charities database website should make pertinent legal documents available to the public so that any interested person could view and download them. The identities of a charitable organization’s current officers should be posted on an appropriate state website as well.1 2 9 191 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4.4.5 Using Audited Self-Regulation The Securities & Exchange Commission (SEC) is responsible for protecting investors and the Federal Deposit Insurance Corporation (FDIQ is responsible for protecting depositors. Both government agencies require die preparation and filing of extensive financial and managerial disclosure reports by qualified non-government actors (e.g., specially trained accountants and lawyers in the private sector). Perhaps more pertinent, the Health Care Financing Administration of the Department o f Health and Human Services administers Medicare and Medicaid payments to qualified hospitals. For hospital reimbursement purposes, the regulations under the Medicare and Medicaid Act allow the federal government to accept as “qualified” those hospitals accredited by the Joint Commission on Accreditation of Health Care Organizations (JCAHO), a private organization founded in the early 1900s.1 3 0 The SEC and FDIC are government regulatory agencies while the JCAHO is a private accreditation agency or self-regulatory organization (SRO). In the nonprofit sector, there is no one agency or organization that evaluates or screens charitable organizations to protect interested stakeholders.1 3 1 For example, the absence o f adequate information means that it is difficult for consumers to evaluate the quality o f hospital patient care (whether the hospital is nonprofit or “for-profit”) and generally impossible for donors to evaluate charitable organizational performance and thus avoid being misled or even duped.1 3 2 One commentator1 3 3 claims that due to the absence of full and fair disclosure the public may not realize that some charitable organizations may be incapable of accomplishing their stated charitable or social welfare missions (they are ineffective), some may get “too little mileage” out of public contributions (they are 192 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. inefficient), some may have corrupt administrators (die problem of private inurement1 *), and some may have inept or neglectful administrators (die problem of jeopardy'3 5 ). To remedy information asymmetries Congress could charter a special corporation to serve as a national accreditation agency or SRO and appoint its directors.1 3 6 This special corporation or SRO would be responsible for resolving the information deficit by promulgating minimum reporting, disclosure, managerial, and governance standards to be followed by all nonprofit charitable organizations for accreditation purposes. In addition to providing the disclosures now required by law (i.e.. Internal Revenue Service Forms 990 or 990-PF), an accredited charitable organization might be required to: • Issue audited financial statements. • Receive public comments and allow interested parties to present testimony at certain board meetings. • Maintain a nominating committee to receive and review applications for new board members. • Implement one or more community advisory committee to help the board manage the organization’s charitable activities. • Maintain a website for all of the above. In addition, Congress could amend the Internal Revenue Code to recognize as a tax-exempt charitable organization only those nonprofit organizations that are actually accredited. The more effective, more efficient, and better-managed charities should have a 1 9 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. strong incentive to support a national accreditation agency that is capable of raising reporting and disclosure standards throughout the United States because, at least in theory, 1 3 7 higher standards would make it difficult for the less effective, less efficient, and worse managed organizations to compete for die same charitable dollars. Religious organizations would also have to apply for accreditation or lose their tax-exempt status, since the First Amendment does not compel Congress to provide any tax exemption for any particular religious group.1 3 8 Similarly, state and local governments would be free to condition their respective tax exemptions on accreditation. 4.5 Conclusions In the early1990s, some consumer and public interest groups became attracted to hospital conversions as a cause celebre because of their potential for the diversion or misappropriation of community health care assets and the opportunities they presented to persons in the private sector for unjust enrichment.1 3 9 Fiscal improprieties that had characterized some earlier hospital conversion transactions, particularly those in states other than California, eventually brought interest group pressure for regulatory reform and produced the legislative “ tipping point” 1 4 0 Regulation is about die politics of interest groups and hospital conversions are no exception.1 4 1 At the state level, California’s 19% hospital conversion law is substantially responsive to the concerns of various community and consumer groups, so much so that the model legislation promulgated by the National Association of Attorneys General in 1998 is almost identical to California’s legislation. Since the beginning of 1997, every 194 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. California hospital conversion has had to run the California Attorney General’s stringent gauntlet of mandatory financial, public interest, and fiduciary review. Thus, each transactional element of every hospital conversion transaction is now subject to administrative and public scrutiny, including financial or economic necessity, the sales and purchase documents, die selling hospital’s financial statements, the appraisal, directors and officers’ compensation arrangements, and die proposed use o f conversion proceeds. At the federal level, the addition of section 49S8 to the Internal Revenue Code of 1986, which imposes special penalty (excise) taxes on “excess benefit transactions” that may occur between public charities and persons in the private sector, will, in addition to California law, exert a particularly strong chilling effect on potential opportunistic behavior. Since September 14, 199S, the effective date of section 4958, below market or “bargain purchase” hospital sales transactions, excessive directors and officers’ compensation arrangements, and all other forms of financial impropriety between charities and private persons are supposed to attract the enmity of the tax collector.1 4 2 With some 500,000 charitable organizations to oversee, the Internal Revenue Service will need to devote significant audit resources to monitoring potentially abusive transactions.1 4 3 Although state and federal laws appear to cover the waterfront, there is room for improvement First current law permits the Attorney General and the courts to formulate and direct the conversion foundation’s spending plan for the conversion proceeds, apparently out of fear that left unchecked, inappropriate or opportunistic spending decisions might be made.1 4 4 The problem is that the Attorney General’s spending plan might not necessarily reflect what the people actually want or need. Moreover, the spending process should be flexible, responsive to new or changed community needs, and, 195 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. as much as possible, die actual expenditure decisions should reflect die will o f die residents of a particular community. Because decisions regarding die use of conversion proceeds are important to the community as a whole, there ought to be public participation in die decision-making process. The use of mandatory committees to advise die management of conversion foundations about die use of conversion proceeds would seem to be an appropriate governance tool, and one that would be relatively easy to implement It would also be less intrusive in internal nonprofit governance than the recommendation that there be mandatory public board members. Second, information asymmetries continue to plague the nonprofit charitable sector. Nonprofit stakeholders, particularly taxpayers, donors, and beneficiaries, do not know what management knows. Without financial and operating information, it is difficult, perhaps impossible, to hold the trustees, directors, or officers o f nonprofit charitable organizations accountable for their actions and remedy any breaches of their fiduciary duties. The Internal Revenue Service's mandatory financial disclosure requirements are an important first step,1 4 5 but more can and should be done. At a minimum, California’s Supervision of Trustees and Fundraisers for Charitable Purposes Act 1 4 6 should be amended to require all nonprofit public benefit corporations to submit copies of Internal Revenue Service Forms 990 or 990-PF and governing documents (i.e., trust agreements and corporate articles) to the Registrar of Charitable Trusts so that the Attorney General’s charities database will be complete. To make the organization’s story intelligible to the general public, on an annual basis the Act should also require the preparation and submission of management’ s discussion and analysis of die nonprofit organization’s results of operations and financial condition for website posting as well.1 4 7 196 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In the case of large nonprofit public benefit organizations (i.e., those with revenues or assets of more than S10 million), audited financial statements should be required and similarly posted. I consider the above recommendations to be minimally essential to improving the hospital conversion process. Although I believe that the California Legislature should consider creating a separate agency (e.g., die “California Department of Charitable Affairs”) to regulate nonprofit charitable organizations, I suspect that that will not occur. I should not be surprised if, eventually, the nonprofit charitable sector were “revolutionized” by sunshine legislation, mandatory public board members, improved standing for charitable beneficiaries, and the implementation of accreditation, but I am less sanguine about any of this being adopted in the foreseeable future. 197 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Chapter 4 1 Daniel M. Fox and Phillip Isenberg, “Anticipating the Magic Moment: The Public Interest in Health Plan Conversions in California,” 15(1) Health Affairs 202 - 209 (Spring 1996). See also Mary Gabay and Sidney M. W olfe, “W ho Controls the Local Hospital? The Current Hospital Merger and Acquisition Craze and the Disturbing Trend of Not-For-Profit Hospital Conversions to For-Profit Status,” Public Citizens H ealth Research Group (June 1996). 2 In California and m ost other states, the assets of a nonprofit public benefit corporation that is exempt from incom e tax under the provisions of Internal Revenue Code of 1986, § 501(c)(3) are always impressed with a charitable trust Thus, it makes no difference whether the legal form of a charitable organization is an express com m on law charitable trust or a nonprofit public benefit corporation. But see Michael W . Peregrine, “Charitable Trust Laws and the Evolving Nature of the Nonprofit Hospital Corporation,” 30(1) Journal o f Health and Hospital Law 1 1 (March 1997). 3 For California’s version of the nondistribution constraint, see Calif. Corp. Code § § 5410, 5420 (Deering’s 2000). 4 Contrary to popular belief the nondistribution constraint is not absolute. It is possible for a charitable conveyance to terminate upon the occurrence of a stated event Thus, at com m on law a donor could transfer land to a nonprofit public benefit corporation upon die condition that the land be used by the nonprofit corporation for specified hospital purposes. Upon breach of the specific use condition, die land could revert to the donor. See Restatement Property § § 44,45 (discussing “estates in fee simple determinable,” which end automatically upon the occurrence of the event stipulated, and “estates in fee simple subject to a condition subsequent " w hich are subject to a retained power of term ination). California law expressly recognizes the continuing validity of these common law conveyances. See, e.g^ Calif Corp. Code § 6715 (Deering’s 2000). For income tax purposes, a charitable contribution deduction will be allowed at the time of the conveyance if the probability of subsequent charitable defeasance is negligible. See 26 Code of Federal Regulations § 1.170A-l(e)(2000). 5 See Austin W akem an Scott, Abridgment o f the Law o f Trusts (Boston: Little, B row n and Company, 1960), § 395 et seq. 6 Austin W akeman Scott, Abridgment o f the Law o f Trusts (Boston: Little, Brown and Com pany, 1960), §391. 7 See, e.g., Calif. Corp. Code § 5250 (Deering’ s 2000). 8 Attorney General v . Hahnemann Hospital, 397 Mass. 820,494 N.E.2d 1 0 1 1 (1986). 198 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 9 Mary v . Lupin Foundation, 609 So.2d 1 8 4 (La. 1992). 1 0 See Suite o f Florida ex rel. Butterworth v . Anclote Manor Hospital, 566 So.2d 296 (Fla. Dist C L App. 1990). Additional facts appear in a memorandum decision of die U.S. Tax Court, Anclote Psychiatric Center v. Commissioner, T .C . M em o. 199S -59S . 1 1 Since 1980, California law has required die Attorney General to be notified, in writing, before a nonprofit public benefit or charitable corporation m ay sell or otherwise dispose of all of its assets. See Calif. Corp. Code § S 913 (Deering’ s 2000). Presumably, this statute was intended to give the Attorney General an opportunity to intervene in a proposed sales transaction to protect the public interest Unfortunately, this statute is too general and it lacks the necessary specificity to regulate hospital conversions in an appropriate manner. More important the new hospital conversion legislation requires die A ttorney General to give his or her affirmative consent to the nonprofit hospital sales transaction. 1 2 Calif. Corp. Code §§5914 - 5925 (Deering’s 2000). 1 3 See Calif. Corp. Code §§ S914 - S 9 2 5 (Deering’ s 2000). See also 1 1 California Code of Regulations § 999.5 (2000). 1 4 See Calif. Corp. Code §§ 5917,5923 (Deering’s 2000). 1 5 Calif. Corp. Code § 5924 (Deering’ s 2 000). 1 6 By law, the California Legislature has given the Attorney General considerable discretion. In general, courts are reluctant to interfere w ith the exercise of administrative discretion unless the plaintiff can demonstrate that the agency’s exercise of discretion was arbitrary, capricious, abusive, or otherwise unlawful. Similarly, the Attorney General’s refusal to review a transaction (e.g., the transaction may be too sm all) m ay be unreviewable. See, e.g., Jerry L . M ashaw, Richard A. Merrill, and Peter M . Shane, Administrative Law: The American Public Law System, 3 "1 ed. (St. Paul, M INN: West Publishing Co„ 1992), ch. 7. 1 7 National Association of Attorneys G eneral, “M odel Healthcare Conversion Guidelines,” (Washington, DC: National Association of Attorneys General, 1998). Even before these guidelines were promulgated, however, m any states had passed specific legislation to codify certain aspects of the hospital conversion process. See David Shactman and Andrea Fishm an, “State Regulation of Health Industry Conversions from Not-for-Profit to For-Profit Status, Council on the Economic Impact of H ealth System Change, Institute for Health Policy, Heller Graduate School, Brandeis University (D ecem ber 30,19%). 1 8 T. J. Sullivan, “Nonprofit Hospital and H ealth Plan Conversions” (Philadelphia: Am erican Law Institute-American Bar Association C ourse of Study Materials, Course No. SE34, September 1999). The author’ s data is from the National Conference of State Legislatures Health Policy Tracking Service, w w w .h p ts .o c o . See also See Kevin F. Donohue, “Crossroads in Hospital Conversions— A Survey of Nonprofit Hospital Conversion Legislation,” 8 Annuals o f Health Law 39 (1999). Donohue’s count (19 199 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. states) is less than Duke University's count (24 slates). See D uke University, Center for Health Policy, Law and Management, “A Guide for Communities Considering Hospital Conversion in the Carolines,” May 1998, ch. VO, available at w w w .h o o lic v .d u fc e .e d u /c v t) e r e x c tia n q e /c o n v ie rs io (V n i« H a h r h t m » 1 9 See Lester M. Salamoo, ed. Beyond Privatization: T h e Tools o f Government Action (Washington, D.C.: The Urban Institute Press, 1989). 2 0 Calif. Corp. Code § 5922 (Decring’s 2000). 2 1 Ibid. 2 2 This does not mean that foe Attorney General must accede to the public’s demands. It only m eans that foe Attorney General’s office must engage in “conscientious decision making" and give due consideration to the vox populi. The public has a right to presents its views and the Attorney General’s office has an obligation to consider them . Having considered them , however, the Attorney General’ s office m ay summarily reject them. See Jerry L. M ashaw , Bureaucratic Justice (New Haven, CT: Y ale University Press, 1 9 8 3 ). 2 3 Calif. Corp. Code §5922 (Deering’s 2000). 2 4 In law , the Attorney General is deemed to represent foe public or the community in seeing that charitable trusts are properly performed See Austin W akem an Scott, Abridgment o f the Law o f Trusts (Boston: Little, Brown and Com pany, 1960), § 391. B y statute, California follows foe com m on law but allows certain other persons to enforce charitable trusts. Calif. Corp. Code § 5142 (Deering’ s 2000). Although foe California Attorney G eneral is a state-wide elected public official, he is politically remote from most communities and thus he may an understanding of a community's specific needs. To determine foe best use of charitable proceeds within a specific community, democratic theory requires the preferences of local residents (voters) m ust be m ade known to asset managers (i.e., foe directors and trustees of charitable organizations). 2 5 See h ttp ://caao .state.ca.u s/ch arittes/n o tices.h tm . printed June 19.2001. 2 6 1 do not mean to suggest that the Attorney General must publish all pertinent transactional documents in a local newspaper. If a member of the public wants to read the transactional documents, be may visit a local office of the Attorney General and procure copies for a fee. Internet posting, however, would probably save everyone’s time and expense. 2 7 Calif. Corp. Code § 5924 (Deering’s 2000). 2 8 Internal Revenue Code of 1986, § 508(a). 2 9 The revocation of a charitable organization’ s tax-exempt status by the Internal Revenue Service is, however, subject to judicial review. See Internal Revenue C ode of 1986, § 7428. 3 0 Internal Revenue Code of 1986, § 6033. 200 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3 1 The Hospital A udit Guidelines are contained in Announcement 92-83,1992-22 Internal Revenue Bulletin 59. 3 2 See Revenue Ruling 98-15, 1998-12 Internal Revenue Bulletin 6. Som e tax practitioners believe that this ruling w as aimed directly at Columbia/HCA Healthcare’ s joint venture activities. 3 3 See Announcement 92-83,1992-22 Internal Revenue Bulletin 59. 3 4 See, generally. Staff of the Joint Committee on Taxation, General Explanation o f Tax Legislation Enacted in the 104* Congress (Washington, D C : U .S. Government Printing Office, 19%), pp. 54-63. 3 5 For a substantial discussion, see American Bar Association Section of Taxation, Committee on Exempt Organizations, “Comments Concerning New Section 4958 of the Internal Revenue Code of 1986,” 50(4) T a x Lawyer 817 - 848 (Summer 1997). 3 6 See Douglas M . M ancino, “Intermediate Sanctions and Changes in Use are Factors in Conversions of T ax Status,” 9(2) Journal o f Taxation o f Exempt Organizations 58 - 7 1 (September/October 1997). 3 7 These examples are m ine. For the temporary income tax regulations under section 4958, see 66 Federal Register 2144 (January 10,2001). 3 8 See 1 1 California C ode of Regulations § 999.5 (2000). 3 9 John F. Coverdale, “Preventing insider M isappropriation of Not-For-Profit Health Care Provider Assets: A Federal T ax Law Prescription.” 73 Washington Law Review I (January, 1998). 4 0 See Calif. Gov. C ode § 12580 et seq. (Deering’ s 2001). 4 1 Calif. Gov. Code § 1 2 5 8 3 (Deering’s 2001). Nonprofit educational institutions, nonprofit health care plans or H M O s, and religious organizations are also exempt. 4 2 See, e.g. Calif. C orp. Code § 5930 (Deering’ s 2001). 4 3 See Internal Revenue Code of 1986, § 6104(d). The applicable regulations actually champion Internet posting. A s a result of this federal disclosure statute, GuideStar is able to post Form 990 information on its ow n website (tww.ouidestar.om l. 4 4 See Peter Swords, “ The Form 990 As An Accountability Tool for 501(c)(3) Nonprofits,” 51(3) Tax Lawyer 571 - 618 (Spring 1998). 4 5 Ibid. 4 6 Ibid. 201 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4 7 See w w w .ss.ca.ao v /b tisin ess/co n > . 48 These figures are as of August 2001. See w w n r .aaq « a a t» » e a u s/c h a ritie s. 4 9 See Lisa M . Bell and Robert B. Bell, “ Supervision of Charitable Trusts in California,” 32(2) Hastings Law Journal 433 - 459 (November 1980). 5 0 Ibid. 5 1 Calif. G ov. Code § 12580 et seq. (Deering’ s 2000). 5 2 Of course, once a nonprofit hospital is sold, the conversion foundation’s Form 990 (or Form 990-PF) w ill be available on the Internet because there is no applicable reporting exemption. 5 3 AICPA Audit and Accounting Guide, Health Care Organizations (New York: American Institute of Certified Public Accountants, 1 9 9 7 ), ch. 1 0 . 5 4 See Financial Accounting Standards Board Statement No. 1 1 7 (June 1993). 5 5 1 bid. 5 6 See Financial Accounting Standards Board Statement No. 1 2 4 (November 1995). 5 7 See 1 7 C ode of Federal Regulations § 229.303 (2000). See, e.g., Ian Molho, The Economics of Information: Lying and Cheating in Markets and Organizations (Oxford: Blackwell Publishers, 1997), ch. 9. 5 9 See Louis Lowenstein, “Financial Transparency and Corporate Governance: You Manage W hat You M easure,” 96(5) Columbia Law Review 1335 - 13 62 (June 19%), and Paul G. M ahoney, “M andatory Disclosure as a Solution to A gency Problems,” 62(3) University o f Chicago Law Review 1 0 4 7 - 1112 (Summer 1995). 6 0 See, e.g., 1 7 Code of Federal Regulations § 229303 (2000). 6 1 Calif. C orp. Code §§5914,5915 (Deering’ s 2000). 6 2 Calif. C orp. Code § 5916 (Deering’ s 2000). 6 3 See, e.g.. Title 5, United States Code, § 553, which deals with “rule making” under the Administrative Procedure Act 6 4 Ibid. 6 5 Ibid. 202 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 6 6 1 1 California Code of Regulations § 999J(eX3XD) (2000). 6 7 See, e.g_ Gary R. Trugman, Understanding Business Valuation (New York: American Institute of Certified Public Accountants, 1998). B usiness valuation software, containing sample reports, is available from several sources, including John Wiley & Sons, Inc. (New York, New York) and the American Institute of Certified Public Accountants (New York, New Y ork). 6 8 Burch v. Bradley, 1 1 C aL App. 3d 680 (1970) (“The role of the Attorney General is as an overseer of charities representing the public....") 6 9 Calif. Corp. Code §§5917,5923 (Deering’s 2000). 7 0 Lynch v . Spilman, 67 C aL 2d 25 1 (1967). 7 1 See Calif. Health & Saf. Code § 127340 etseq. (Deering’s 2000). 7 3 See, e.g., Rob Atkinson, “Reforming Cy Pres Reform,’ ’ 44 Hastings Law Journal 1112 (July 1 9 9 3 ). 7 3 See Appendix C, the Technical Appendix to Chapter 3. 7 4 Ibid. 7 5 See, e.g., Calif. Corp. Code § 5930 (Deering’ s 2001). 7 6 See H arry Snyder and Deborah Cowan (eds.), "Building Strong Foundations: Creating Com m unity Responsive Philanthropy in N onprofit Conversions,’ * Consumers Union, 2000. 7 7 See, e.g., Robert E. Litan and William D . Nordhaus, Reforming Federal Regulation (New H aven: Yale University Press, 1983); Susan Rose-Ackerman, Rethinking the Progressive Agenda: The Reform o f the American Regulatory State (New York: The Free Press, 1992). 7 8 See, e.g., David L . Weimer and Aidan R. V ining, Policy Analysis: Concepts and Practice. 2 * d ed. (Englewood Cliffs, NJ: Prentice Hall, 1 9 9 2 ). 7 9 Paul C . Light, Making Nonprofits Work: A Report on the Tides o f Nonprofit Management Reform (Washington, DC: Brookings Institution Press, 2000). 80 Ian M olho, The Economics o f Information: Lying and Cheating in Markets and Organizations (O xford: Blackwell Publishers, 1997). 8 1 Calif. Corp. Code §5210 (Deering’s 2000). 8 2 California Attorney General Press Release N o. 97-017 (February 21,1997). 203 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 8 3 The California Attorney General’s review protocol for the sale or other transfer of a nonprofit hospital requires that the transferor’ s board consider die hospital’ s financial viability (both short term and long-term) as well as all realistic alternatives to an outright sale. See 1 1 California Code of Regulations § 999.5(e)(3)(F) (2000). 8 4 In the Matter o f the Manhattan Eye, Ear A Throat Hospital, 186 Misc.2d 126,715 N.Y.S.2d 5 7 5 (N.Y. Sup. C L, 1 9 9 9 ). The operative statute required the court to be satisfied that the consideration and term s of the transaction were “fair and reasonable’ ’ to the selling nonprofit corporation. 8 5 Calif. Gov’t Code § 54950 et seq. (Deering’ s 2000). The complete text and the A ttorney General’s analysis of the Brown Act can be viewed on the Internet See Office of the A ttorney General, “The B row n Act Open Meetings for Local Legislative B odies," h ttp ://caaQ .state.ca.u s /p m /b ro w n .a c t. For a detailed exposition, see Administrative Law, 2 Cal Jur 3d (Rev) Part 1 A , § 1 0 4 etseq. 8 6 The Bagley-Keenc O pen Meeting Act enacted in 1967, extended the Ralph M . Brow n Act’ s “sunshine in government" principles to state bodies. See Calif. Gov’t Code § 111 2 0 et seq. (Deering’s 2000). 8 7 Stephen G. Breyer and Richard B . Stewart, Administrative Law and Regulatory Policy, 2 n d ed. (Boston: Little, B row n and Company, 1985), p. 1257. 8 8 See discussion in Administrative Law, 2 Cal Jur 3d (Rev) Part 1 A, § 1 0 4 et seq. 8 9 See Calif. Gov. C ode § 54952(cX 1 ) (Deering’ s 2000). 9 0 See 70 Op. Atty. G en. Cal. 57 (No. 86-502, issued April 1,1987). 9 1 The Attorney General has also ruled that the statutory requirements of the Brown Act may not be avoided by delegating administrative responsibilities to a nonprofit public benefit corporation. See 8 1 Op. Atty. G en. Cal. 281 (No. 98-406, issued August 27,1998). 9 2 See Citizens for Public Accountability v. Desert Health Systems et al., 1 9 8 CaLApp.3d 1 0 6 7 (1988) (decision ordered not published by a minute order of the California Supreme Court, but available unofficially from Lexis-Nexis), discussing Yoffie v . Marlin Hospital District, 1 9 3 CaI.App.3d 743 (1987). 9 3 For an elementary discussion of the Brown Act, see Paul J. Dostart and Jessica A. Fortner, “ T ax Practice in the Sunshine: Application of die Open Meetings Law to Non-Govemmental Entities," 7(2) California Tax Lawyer 3 -9 (Spring 1998). 9 4 An extension of the B row n Act to nonprofit religious corporations would raise First A m endm ent considerations. I do not advocate that However, “public policy" limitations do apply to charitable organizations that are also religious. See, e.g.. Bob Jones University v . United States, 461 U.S. 574 (1983) (upholding the revocation of federal tax exempt status due to the practice of racial discrimination). 204 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 9 5 Trustees o f Dartmouth College v. Wood wa rd, 1 7 U.S. (4 Wheat) 518 (1819). 9 6 U.S. Const, Ait I, § 10, Cl. 1 : “No Stale shall. . . pass any... Law impairing the Obligation of Contracts... 97 Calif. Const, Art XX, § 5 :“A 1 1 laws now in force in this State concerning corporations and all laws that m ay be hereafter passed pursuant to this section may be altered from time to time or repealed.” 9 8 See, e.g., Rainey v. Michel, 6 CaL 2d 259 (1936) (reaffirming that under the state constitution, the legislature indeed has the power to change the state’s contract with stockholders). See also Tu-Vu Drive-In Corporation v. AshJdns, 6 1 Cal. 2d 283 (1964) (discussing retroactivity an d holding it to be permissible, even to a stockholder’s economic and legal detriment). 9 9 For a philosophical exposition on “slippery slope” legal claims, see Frederick Schauer, “Slippery Slopes,” 99 Harvard Law Review 361 (December 1985). 1 0 0 See, e.g., Zumbrun v . University o f Southern California, 25 Cal. A pp. 3d 1 (1972) (holding that USC's catalogues, bulletins, and circulars are part of its contract with its students, and a student may sue the university for breach of contract). 1 0 1 See, e.g., P aul G . Haskell, “The University as Trustee," 17 Georgia Law Review I (Fall 1 9 8 2 ). 1 0 2 Current law would require the museum’ s directors to give notice to the Attorney General. S ee Calif. Corp. Code § 5913 (Deering’ s 2000). However, I know of no movement to extend the intricate provisions of California’ s hospital conversion law to all nonprofit public benefit corporations. To protect relevant stakeholders perhaps the law should be extended, but no on e seems to be lobbying for that result 1 0 3 For a theory of political attitude or positional change that might be relevant to modeling the public’ s ability to influence board members, see John R. Zaller, Th e Nature and Origins o f M a s s Opinion (Cambridge, England: Cambridge University Press, 1992), ch. 9. 104 Henry Hansm ann, The Ownership o f Enterprise (Cambridge, M A : Harvard University P ress, 1996), ch. 1 2 . 1 0 5 The assets are quasi-governmental because, under traditional theory, they represent governm ent subsidies to the charitable organization and its donors. There are, however, other views. S ee, e .g _ , Frances R . Hill and Barbara L . Kirschten, Federal and State Taxation o f Exempt Organizations (Boston: Warren, Gorham & Lamont, 1994), ch. 1 5 . For tax expenditures as a tool of government spending, see Lester M . Salamon, ed.. Beyond Privatization: The Tools of Government Action (Washington DC: The Urban Institute Press, 1989), ch. 6. For an insight into the politics of tax expenditures, see Christopher Howard, The Hidden Welfare State: T a x Expenditures and Social Policy in the United States (Princeton, N J: Princeton University Press, 1997). 205 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 0 6 See, e.g-, Jody Freeman, “Privatization: Private Parties, Public Functions and the New Administrative Law ,” 52 Administrative Law Review 813 (Summer 2000). 1 0 7 See Calif. Corp. Code § 5914 (Deering’s 2000). 1 0 8 These monetary limits are arbitrary but they are designed to filter out small charitable organizations in an effort to m inim ize their cost of compliance. According to the California Attorney General, only 1,522 of die states total registered charities (81,722) have assets over S10 million. See www.caaa.state.ca.us/charities. 1 0 9 See George Pepperdine Foundation v . Pepperdine, 126 Cal.App.2d 154 (1954) (finding no director liability for mismanagement). 1 1 0 Since the California Attorney General refused to intervene in the litigation and M r. Pepperdine was the organization's substantial donor, nothing could be done to remove him from office. M r. Pepperdine w as a capable businessman but a poor director or fiduciary for his private foundation. 1 , 1 Calif. Corp. C ode § 5151(a) (Deering’ s 2000). 1 1 2 Evelyn Brody, “Agents Without Principals: The Economic Convergence of the Nonprofit and For-Profit Organizational Forms, 40 New York Law School Law Review 457, 488 (19%). 1 1 3 See Calif. Corp. Code § 5142 (Deering’s 2000). 1 1 4 Sec Calif. B us. & Prof. Code § 450 et seq. (Deering’ s 2000). ! 1 5 Calif. Bus. & P rof. Code § 5000 (Deering’s 2000). 1 1 6 Early in its history, die Union Pacific Railroad used “public directorships.” Although stock was issued in the private sector, perhaps Congress considered the Union Pacific to be a “public corporation.” S ee Christopher D. Stone, Where the Law Ends: The Social Control o f Corporate Behavior (N ew York: Harper & Row, 1975), ch. 1 5 . 1 1 7 The “police pow er” is simply the intrinsic power of a sovereign state (e.g., California) to regulate otherwise private rights of property and contract Thus, the police power permits a state to regulate business interests, and its principal limitation is die Due Process Clause of die Fourteenth Amendment 1 1 8 See “Programs and Services” on the California Attorney General’s website, www.caao.state.ca.us. 1 1 9 See California Attorney General Press Release No. 99-077 (October 6, 1999), announcing the first budget increase in sixteen (16) years for the Attorney General’s Charitable Trust Section to permit the operation of the searchable charities database, www.caao.state.ca.us/charities. 1 2 0 See Calif. Bus. & Prof. Code § 300 er seq. (Deering’s 2000). 206 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 2 1 See Calif. Bus. & Prof Code § 321 (Deering’s 2000). 1 2 2 See Calif. Bus. & Prof. Code § 326 (Deering’ s 2000). 1 2 3 See Restatement, Second, Trusts § 391, com m ent c. 1 2 4 See Lisa M . Bell and Robert B. Bell, “ Supervision of Charitable Trusts in California,” 32(2) Hasting? Law Journal 433 - 459 (Novem ber 1980). 1 2 5 Calif. Corp. Code § S142 (Deering’ s 2000). Although statutory “members" may bring derivative actions to correct a breach of charitable trust, as previously mentioned most nonprofit public benefit corporations do not have statutory “m em bers." See Calif Corp. Code §§ 5142, 5710 (Deering’ s 2000). 1 2 6 The Supreme Court’ s decision in Goldberg v . Kelly, 397 U.S. 254 (1970), extended due process procedural safeguards to government benefits and privileges. Whether or not these or similar safeguards should be extended to the beneficiaries of charitable corporations and trusts is a pertinent question. See Rob Atkinson, “Unsettled Standing: W ho (Else) Should Enforce die Duties of Charitable Fiduciaries?” 23 Journal o f Corporation Law 655 - 699 (Summer 199 8 ). 1 2 7 See Calif. Pub. Util Code § 1702 (Deering’ s 2000). 1 2 8 In essence, the Attorney General would be required to grant “relator status” to a member of the group for the group’s benefit. See Calif. Corp. Code § 5142(a)(5) (Deering’s 2000), and II California Code of Regulations § 1 et seq. (2000). 1 2 9 Upon written application this information is currently available from the California Secretary of State. See w w w .ss-c a.o o v /b u sin e ss/c o n > . Internal Revenue Service Forms 990 and 990-PF require information about officers, directors, key employees, and their compensation arrangements. 1 3 0 Douglas C. Michael, “Federal Agency U se of Audited Self-Regulation as a Regulatory Technique,” 47(2) Administrative Law Review 1 7 1 - 253.217-227 (Spring 1995). 1 3 1 Since 1918, die National Charities Inform ation Bureau, which evaluates nonprofit charitable organizations, has advised contributors. The current “Wise Giving Guide” lists almost 400 national charities. See www.oive.orQ. In 1 9 7 1 , the Philanthropic Advisory Service of the Council of Better Business Bureaus began a similar program. See www.bbb.oro. Voluntary accreditation agencies exist in many fields, including health care and education. In the early 1900s the American College of Surgeons began the Joint Commission on Accreditation of Hospitals (now the Joint Commission on Accreditation of H ealth Care Organizations) to set minimum standards for American hospitals. 1 3 2 See Leslie G. Espinoza, “Straining the Quality of M ercy: Abandoning the Quest for Inform ed Charitable Giving,” 64 Southern California Law Review 605 (March 1991). 1 3 3 See Regina E. Herzlinger, “Can Public Trust in Nonprofits and Governments be Restored, Harvard Business Review (March - April 1 9 9 6 ), p. 97. 207 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 3 4 Thus, donors may give money to charities that have figurehead directors, poor internal controls, and corrupt administrators, as some donors did in the case of William Anunony, the former President of United Way of America, who was sentenced to seven years in prison for fraud and embezzlement. United Stales v. Aramony, 1 6 6 FJd 655 (4* Cir. 1999), cert denied, 526 U .S. 1146 (1999). The directors were “over-extended executives and status-seeking lawyers or financiers” w ho did not have sufficient time to devote to the activities and affairs of United W ay. As a result. United Way of America was Aramony’s personal fiefdom. See James J. Fishm an and Stephen Schwarz, Nonprofit Organizations: Cases and Materials, 2* ed. (N ew York: Foundation Press, 2000), p. 228 - 230. In the case of the trustees of the Bishop Estate, a situation that is well known in the State of Hawaii, the trustees received excessive compensation and participated in “insider” business arrangements for their personal benefit Not until the Internal Revenue Service threatened to revoke the B ishop Estate’s charitable tax exemption did the trustees resign. The Suprem e Court of Hawaii w as severely embarrassed because it had appointed the trustees to their positions. See Evelyn Brody, “A Taxing Time for the Bishop Estate: W hat is the I.ICS. Role in Charity Governance?" 2 1 Hawaii Law Review 537 (Winter 1999). 1 3 5 The directors or trustees of a charitable organization may be incompetent or disinterested. In the case of Adelphi University, the president and the directors neglected their duties to the university’s financial detriment. See Susan N. Gary, “Regulating the Management of Charities: Trust Law, Corporate Law, and Tax Law," 21 Hawaii Law Review 593 (Winder 1 9 9 9 ). In the case of the Foundation for New Era Philanthropy, many charities gave their investment moneys to New Era, a corporation that purposed to be a charitable conduit but actually w as an illegal Ponzi schem e. See James J. Fishman and Stephen Schwarz, Nonprofit Organizations: Cases and Materials. 2 “* ed. (New York: Foundation Press, 2000), pp. 243 - 244. 1 3 6 See Douglas C . Michael, “Federal Agency Use of Audited Self-Regulation as a Regulatory Technique," 47(2) Administrative Law Review 1 7 1 - 253, 217-227 (Spring 1995). 1 3 7 See Ian M olho, The Economics o f Information: Lying and Cheating in Markets and Organizations (Oxford: Blackwell Publishers, 1997). i v o Under the First Amendment, tax exemptions are permissive but not mandatory. See, e.g., Wal z v . Tax Commission, 397 U.S. 664 (1970), and Hernandez v . Commissioner o f Internal Revenue, 490 U.S. 680 (1989). 139 For a brief review of die problems, see Lawrence E. Singer, “The Conversion Conundrum : The State and Federal Response to Hospitals’ Changes in Charitable Status," 23 (2 & 3) American Journal o f La w & Medicine 221- 250 (1997). 1 4 0 Malcolm G ladw elL The Tipping Point: How Little Things Ca n Make a Big Difference (Boston: Little, Brow n and Company, 2000). 1 4 1 See James Q . W ilson, ed.. The Politics o f Regulation (New Y ork: Basic Books, Inc., 1980), ch. 10. 208 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 4 2 American Bar Association Section of Taxation, Com m ittee on Exempt Organizations, “Comments Concerning New Section 4958 of the Internal Revenue Code of 1986,” 50(4) Tea lawyer 817 -848 (Summer 1997). 1 4 3 Ibid. 144 — See, e.g_ Michele Bitoun B lecher, “Show Us the Money: State Officials Want to K now H ow Foundations Created by Hospital Sales Plan to Spend Their R iches,” 71(12) Hospitals & Health Networks 52 - 54 (June 20,1997). 1 4 3 For a summary of these requirements, see Randall W. Luecke, Kevin J. Shortill, and David T. Meeting, “Toward Increased Accountability,” Journal o f Accountancy 49 - 56 (October 1999). 1 4 6 Calif. Gov’t Code § 12580 et seq. (Deering’s 2000). 1 4 7 See, e.g., 17 Code of Federal Regulations § 229.303 (2000). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 5 Conclusions 5.1 Introduction During the past decade, a spate of stories about hospital conversions to “for-profit” from “non-profit” status has produced public clamor for legislative reform.1 Whether exaggerated or not, these stories raised the consciousness of legislators and regulators and thus they produced, conectly or incorrectly, the “tipping point” for social action.2 The result has been important changes in the law, especially in California for non-profit hospital sales occurring after December 31, 1996. Because the assets of a non-profit hospital are required to remain in charitable solution indefinitely, die sale of a non-profit community hospital facility is tantamount to the monetization of a community asset and die concomitant redeployment of charitable capital for other, ostensibly more important, community purposes. Rather than discouraging conversions and requiring public capital to be retained in obsolete public hospital enterprises, die law should promote economic efficiency by permitting conversions so that community health care capital can be recouped and reinvested when and where it will do die most good. In essence, hospital conversions represent a form of privatization because they seek to entrust tax expenditures, which are 210 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. essentially equivalent to government grants,3 to private sector charitable organizations to deliver health and social welfare benefits to the residents of a particular community.4 Before summarizing the principal findings of the case studies under California’s hospital conversion law, one should examine the law’s rationale. It is important to understand that California’s hospital conversion legislation does not abrogate existing law. Rather, it adds to it special scrutiny and empowerment provisions applicable only to “health facility” transactions.5 Under California law (at least since 1980), the board of directors of any nonprofit public benefit corporation (e.g., a nonprofit hospital, a nonprofit museum, or a nonprofit educational institution) could sell “all or substantially all” of the corporation’s assets “upon such terms and conditions and for such consideration as the board may deem in the best interests of the corporation” to any person.6 To protect the public interest in charitable assets, the board of directors was always required to give preliminary written notice (at least 20 days) of an asset sale to the Attorney General, who was then free to choose whether or not to intervene in the proposed transaction.7 If the Attorney General thought that the proposed transaction might constitute a breach of charitable trust, his only remedy was to bring an action to enjoin the transaction.1 He had no statutory power to impose terms and conditions on the proposed transaction in an effort to remedy the perceived breach of charitable trust California’s hospital conversion statutes do not change the fundamental principals mentioned above. Rather, they merely add additional measures to protect the public interest if the nonprofit seller happens to be a hospital or other “health facility,” and the Attorney General now has more time to review the proposed transaction (at least 60 days).9 The hospital conversion statutes require the Attorney General to exercise due diligence and 211 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. they permit him to impose terms and conditions upon his consent to the conversion transaction. In essence, the hospital conversion statutes permit, and perhaps even require, the Attorney General to be a “dealmaker” between a charitable corporation and a third party. Before 1996, nothing in the California Corporations Code sanctioned deal making. After 19%, the Attorney General may act as a “dealmaker” in connection with the sale of a nonprofit health facility to a “for-profit” corporation. Some critics think that since government or bureaucratic failure 1 0 was never proven, California’s hospital conversion law amounts to a very costly and administratively impractical gilded lily." There have been some instances of egregious valuation errors and unjust enrichment, and it is probably fair to say that some state attorneys general may have neglected their charitable oversight responsibilities by failing to supervise the monetization process in a satisfactory manner. The California experience, however, belies this. Perhaps the real significance of California’s hospital conversion law is that it articulates an enforcement menu, it gives the Attorney General broad statutory powers to regulate hospital and other health facility conversions, and it expressly permits the Attorney General to be a dealmaker and facilitator of nonprofit hospital sales. A speculative question is whether the Attorney General’s role as a dealmaker might actually facilitate the sale of nonprofit community hospitals which should be sold for various reasons so that monies held in charitable trust can be used elsewhere; e.g., perhaps the hospital is technologically obsolete or there is surplus hospital capacity within the community. Another interesting question is whether corporate investors that have purchased “non-profit” community hospitals have made sound investment decisions. At this time, the extent to which purchasers such as Columbia/HCA, OrNda, and Tenet have 212 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. experienced buyers’ remorse due to operating losses instead of anticipated profits is unknown. Losses in the private sector due to over-pricing may inhibit further conversions and even require concessions to motivate future investors to purchase unwanted nonprofit hospitals.1 2 5.2 Principal Findings of the Case Studies Under California’s 1996 hospital conversion law, the Attorney General’s first important principal decision is whether or not to allow the sale of a “non-profit” community hospital to a “for-profit” corporate investor or hospital chain to occur. Before 1997, California law permitted the Attorney General to intervene in hospital conversion transactions but there was no express requirement that he actually do so.1 3 In practice, the Attorney General scrutinized the larger hospital conversion transactions (e.g., the 199S sale of Good Samaritan Health System for S16S million to an affiliate o f Columbia/HCA Healthcare) but gave short shrift to the smaller ones (e.g., the 1996 sale o f Pacific Hospital of Long Beach for S5.5 million to HealthSmart Pacific). Given the Attorney General’s limited resources I would not have expected to see otherwise. A criticism o f California’s hospital conversion legislation is that it may have forced the Attorney General to devote to nonprofit hospital transactions scarce resources which should have been devoted to more pressing law enforcement problems. Since the enactment of California’s hospital conversion law, the Attorney General has sought to apply a high threshold of financial and community necessity to all hospital conversion transactions. Thus, in early 1997 the Attorney General effectively terminated 213 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the proposed sale of Sharp Healthcare to Cotumbia/HCA Healthcare for approximately $225 million because he thought that Sharp’s board of directors had not adequately considered “all realistic alternatives’ *1 4 to improve the hospital’s financial condition.1 5 The Attorney General also thought that Columbia’s offer of approximately S228 million was at least $100 million too low, although (as the technical appendix to Chapter 2 demonstrates) Shattuck Hammond’s estimate o f hospital value ($360 million - $390 million) was arguably too high. Query whether or not the Attorney General was correct to deny the sale solely for purchase price considerations. What if the hospital should have been sold (for sound reasons) and the community is now economically burdened by a “failed” sale due to over-zealousness on the Attorney General’s part? The potential for over regulation has not gone unrecognized.1 6 An additional wrinkle in Sharp was Columbia’s desire to give the selling hospital an equity interest in a “for-profit’ ’ joint venture company, coupled with the legal right to compel Columbia to purchase that interest at a future date (a “put”)- Documents in the public transaction file suggest that Sharp’s board of directors did not understand the monetary consequences of die “pu t” In the light of the mathematical complexities of basic options theory, the board’s lack o f knowledge is certainly understandable.1 7 The board did not understand that the value o f Columbia’s particular “put” would erode over time. Similarly, but for the Attorney General’s mandatory intervention in the 1997 sale of Riverside Community Hospital to Columbia/HCA Healthcare for $70.3 million. Riverside’s apparently unsophisticated board of directors would have accepted an equity interest in a joint venture “for-profit” hospital company without any means of compulsory asset monetization.1 6 The Attorney General required a “put” to protect die value of the 214 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospital’s assets as a condition to approving die sale. These two instances certainly support some of die concerns of the advocates of hospital conversion legislation. The Attorney General’s second important principal decision is whether or not to approve the proposed sales price and the form of economic consideration. The decision to monetize a community “non-profit” hospital by allowing its assets to be sold to a “for- profit” hospital necessarily entails an exercise in asset pricing. Before 1997, California law did not require the Attorney General to examine the transaction’s “fair market value” or the financial economics of its terms and conditions. In practice, the Attorney General sought to ascertain transactional values by using outside consultants, especially for some of the larger hospital conversion transactions; e.g., in connection with the 19% sale of Centinela Hospital Medical Center to OrNda HealthCorp for $%.8 million, the Attorney General obtained a “fairness opinion” from the investment banking firm of Morgan Stanley. Since 1997, the Attorney General has had a statutory obligation to determine a selling hospital’s fair market value. The valuation case studies, which the technical appendix to Chapter 2 contains, demonstrate that valuation is an art, not a science. In almost all cases, a wide range of business enterprise value exists. Unfortunately, the Attorney General’s valuation practices are somewhat deficient because his outside valuation reports (whether pro-1997 or post-1996) do not contain sufficient sensitivity matrices nor do they comply with generally accepted competency and independence standards. If this dissertation has uncovered a “smoking gun,” this would appear to be it Perhaps the principal lesson is that it is not enough to hire outside experts to produce business appraisals or valuation reports; the Attorney General needs to acquire in-house expertise to better understand and evaluate the submissions of his hired experts. Is there 215 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. any economic significance to this lack of in-house expertise? I suspect not, because in each case I found the hospital’s valuation to be within a reasonable range. The Attorney General’s third important (and final) principal decision is to determine how the proceeds of the hospital sale should be used for die community’s benefit Here the criticisms are two-fold. First the law that tells the attorney general how to determine the use of the conversion or sales proceeds is too restrictive because it looks backwards (to the hospital’s historic charitable purposes and use o f charitable monies), not forwards.1 9 Second, there is no element of public participation in the expenditure decision making process. A better law would allow the directors and officers of the conversion foundation to use the sales proceeds to fund a variety of community health and welfare benefits, subject only to a duty to consult with an advisory committee that contains representatives of local consumer and community interest groups. Senator Maddy’s proposal (which is discussed in Chapter 3) coupled with public participation would eliminate the Attorney General’s ’ ’ micro-management’ * of die expenditure process and thus foster decision-making that is more responsive to local community needs, both current and changing. Although other groups, particularly Consumers Union, believe that hospital sales proceeds should be used only to fund indigent health care, that use would seem to be too restrictive and contrary to the will of the people. If there is a mandatory advisory committee with appropriate community representation to assist a conversion foundation’s management to establish and monitor a community’s expenditure preferences, that should be sufficient for die Attorney General— and Consumers Union. 216 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Actually, the use of hospital conversion proceeds by conversion foundations may dwarf all other regulatory considerations. Fortunately, interested consumer and community groups can track the use of conversion proceeds by conversion foundations because of the Attorney General’s charities database, www.caao.state.ca.us/charities. The principal rational for this database is that given access to financial information (i.e.. Internal Revenue Service Forms 990 and 990-PF), prospective and existing donors can make intelligent decisions whether or not to support a particular charity. As some commentators have argued,2 0 [TJhe disclosure approach would eliminate 95 percent o f the credibility problems currently experienced by charitable organizations simply because charities will know that their financial affairs will routinely become public. Few will abuse public trust if they know with certainty there will be found out (351) The database is supposed to include Forms 990 or 990-PF filed for years ending after July 1, 1998. Unfortunately, I found substantial omissions and thus it was not possible for me to use the Attorney General’s database to obtain Forms 990 or 990-PF for the conversion foundations studied in this dissertation, although some information was available from GuideS tar (www.ouidestar.om-l A major shortcoming is that the database does not include a charitable organization’s governing legal documents (i.e., its agreement of trust or, more commonly in California, its articles of incorporation). Without these documents it is difficult for interested persons to determine whether or not a conversion foundation (or any other charitable organization for that matter) is using its charitable assets as permitted by law. To make effective the public’s ability to monitor the use of hospital conversion proceeds, 217 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. die corporate articles of nonprofit public benefit corporations should be placed in die Attorney General’s charities database for website posting. Finally, there are two other suggestions that might improve public disclosure and organizational accountability. First, financial disclosure is a good idea but some financial acumen is necessary to navigate Forms 990 and 990-PF to ferret out nuggets of useful information. There is no requirement that a charity prepare and submit an annual report which describes in “plain English” its activities and financial condition for its most recent year. Such a report would help the readers of Forms 990 and 990-PF to understand their significance. Second, nonprofit hospitals are not required to file Forms 990 with the Attorney General’s Registrar of Charitable Trusts for inclusion in the database. The hospital exemption should be removed from the law so that interested persons (e.g., consumer and community interest groups who want to know why a hospital is being sold) can readily determine a nonprofit hospital’s financial condition. S3 Charting a Path to Reform A dissertation is supposed to be a springboard for reflection and future research. Chapter 4 presents die unoriginal view that nonprofit (charitable) organizations suffer from a variety of pathologies that can be remedied by the tools of sunshine, intrusive public participation, disclosure, or greater regulation. Of concern is that these tools may represent solutions to regulatory or public interest problems that do not actually exist Over regulation can be as inimical to the public interest as under regulation. 218 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Nonprofit hospitals provide essential health care and other services to community residents and their unique status has led to favorable tax treatment by federal, state, and local government2 1 For 1995, the income and property tax exemptions alone for nonprofit hospitals were thought to be worth more than $6 billion, and die lost tax revenues due to the income tax deduction for charitable contributions to nonprofit hospitals was thought to be more than $1 billion.2 2 Thus, in the case of nonprofit hospitals, on an annual basis, and with limited or, more often than not, no oversight, private citizens are effectively managing billions of dollars for public health care purposes. Because nonprofit organizations have no real principals, some oversight is prudent to minimize waste and prevent corruption in office. But what kind of oversight and how much should there be? Prior to 1976, there was no federal “Government in the Sunshine Act” 2 3 and citizens had no right to attend meetings of federal regulatory agencies. Congress’ enactment of the federal sunshine law prompted most states to follow suit and enact similar “open meeting” laws. Democracy demands accountability to the electorate, and this means that the electorate must be able to scrutinize the activities of government actors who have the power to affect its interests.2 4 The directors of nonprofit hospitals are non-government actors whose activities affect the public interest because of the importance of health care. In theory the directors are accountable to the Attorney General who represents the public interest, but in practice the Attorney General is a relatively passive monitor because of resource constraints. Residents of the community who use the nonprofit hospital’s services are in the best position to monitor the hospital’s activities and report their concerns, if any, to the Attorney General. An extension of the open meeting requirements of the Ralph M. Brown 219 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Act to nonprofit hospitals would not have to be disruptive or intrusive. For example, in lieu of requiring open board meetings, the law might require all nonprofit hospitals to hold an “annual community meeting” so that interested parties could receive information about the hospital's financial and operating affairs and present relevant testimony to board members. This would seem to be a logical extension of the existing "community benefits plan” requirements of California law.2 5 I have previously commented that the reporting and filing exemptions that are contained in California’ s “Supervision of Trustees and Fundraisers for Charitable Purposes Act” 2 6 should be repealed so that all nonprofit public benefit corporations, including nonprofit hospital corporations, would be required to file Internal Revenue Service Form 990 with the Attorney General. This would permit Form 990 to be included in the Attorney General’s charities database and it would facilitate the public disclosure of financial information. I do not see any need to press for intrusive public participation (e.g., “public board members” 2 7 ) or greater regulation (e.g., “Charity Commissioners) because I think that financial disclosure coupled with the provisions o f existing law would be more than adequate—for all nonprofit organizations. My principal concern is that the non-profit hospital conversion debate may have temporarily obscured a more important public policy issue. During the past decade, a number of commentators have reflected upon the fact that, except for the nondistribution constraint, there is relatively little commercial difference between a tax-exempt, nonprofit public benefit hospital enterprise and a “for-profit” commercial hospital enterprise.2 * There is a perception that tax-exempt community or public benefit hospitals have traditionally provided extensive charitable health care services for the medically indigent 220 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and the underinsured, but the truth is largely otherwise.2 9 The rational for the tax-exempt status of community hospitals is now under attack by die Internal Revenue Service and by state and county governments seeking additional sources of revenue.3 0 Contrary to popular belief, non-profit hospitals per se are not entitled to tax- exempt status. In fact, the Bureau of Internal Revenue (now the Internal Revenue Service) was originally skeptical of granting tax-exempt status to non-profit hospitals because they tended to be controlled by small groups of physician-investors for pecuniary gain or profit In fact litigation was necessary to establish the tax-exempt status of many non-profit hospitals.3 1 Finally, in 19S6, the Internal Revenue Service issued a public ruling to the effect that in order to be tax-exempt a non-profit hospital must furnish some charity care to the medically indigent and avoid private inurement3 2 Although never quantified, the charitable patient care requirement of the 19S6 ruling was short-lived. When Congress passed the Medicare and Medicaid statutes in 1965, it substantially eliminated the need for tax-exempt or non-profit hospitals to establish financial policies to treat indigent patients because, under the 1965 legislation, indigent patients were typically eligible for Medicare or Medicaid and only those not covered by the federal programs would receive their health care in hospital emergency rooms.3 3 Consequently, there was no public pressure for the Internal Revenue Service to enforce the “charity care” requirement of its 1956 ruling. Over the years, slight income tax policy changes have been made. In 1969, the Internal Revenue Service publicly ruled that to be tax-exempt a non-profit hospital need only operate a full-time emergency room “open to all persons” regardless of ability to pay.3 4 In 1983, the Internal Revenue Service publicly announced that “free” emergency 221 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. room care is not necessary for the maintenance of tax-exempt status if the emergency room would “unnecessarily duplicate emergency services and facilities that are adequately provided by another” hospital in die same community.3 3 Finally, in 1992, the Internal Revenue Service emphasized that to be tax-exempt a non-profit hospital should have the following characteristics:3 6 • A diverse governing board composed of prominent civic leaders rather than hospital administrators and physicians; • A medical staff that is open to all “qualified physicians in the area;” • A full-time emergency room that is open to everyone regardless of ability to pay; and • A willingness to provide non-emergency care to everyone in the community who is able to pay either privately or through third-party insurance, including Medicare and Medicaid. In addition to the above, a non-profit hospital must not offer greater personal service compensation and benefits to physicians who use the hospital’s facilities to treat profitable paying patients than to those who use the same facilities to treat lesser paying patients and the medically indigent The prohibition on excessive private benefit or private inurement extends to compensatory benefits of every kind, including financial assistance to physicians for home and medical equipment purchases. The Internal Revenue Service has yet to promulgate quantitative guidelines pertaining to the rendition of indigent medical care services as a precondition to a 222 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospital’s entitlement to tax-exempt status. Many people would be surprised to learn that the average (mean) amount of charity care may be five percent or less of a non-profit hospital’s net patient service revenue.3 7 Actually, it is difficult to assess the amount of charity or indigent medical care because, under generally accepted accounting principles for hospitals, charity care does not qualify for financial statement recognition; i.e., no patient receivable or patient revenue is to be recorded or otherwise recognized.3 * Instead, the amount of charges “foregone” for services and supplies furnished under a hospital’s charity care policy is required to be disclosed in a note to die financial statements based on the hospital’s established “rates, costs, units of service, or other statistical measure.” 3 9 Because established “rates” may be used instead of “costs,” a hospital’s actual out-of- pocket expenditures (or marginal cost) for charity care may be overstated. The growing competition controversy, the relatively small amount of charity care that is currently being proffered by some non-profit community hospitals, and the demands of state and county treasurers for new sources of revenue are factors that are likely to lead to the loss of tax-exempt status for many community or public benefit hospitals. In the late 1940s, the County of Los Angeles sought, unsuccessfully, to partially revoke die tax- exempt status of several Los Angeles area hospitals, including Cedars of Lebanon (now Cedars-Sinai Medical Center), Queen of Angels Hospital, and the Hospital of the Good Samaritan.4 0 Last year, however, the California Legislature instructed the Attorney General to prepare a plan to evaluate the future of nonprofit hospitals in California. At the legislature’s direction, the Attorney General’s plan must consider the amount of charitable care that nonprofit hospitals provide to California residents in the light of their tax 223 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. subsidies and other government costs.4 1 This time, the stakes may be considerably greater than they were fifty years ago. 5.4 The Lesson of Regulation Whether California’s hospital conversion legislation is justifiable is a difficult question. Regulation is expensive, time consuming, and potentially inefficient for government actors. Thus, legislators are frequently admonished to consider regulation from at least three perspectives: the benefits produced, the costs imposed, and the effect on productivity which, in the case of hospital conversions, means the ability of managers in the private sector to direct charitable assets to more efficient uses.4 2 In both economic and social regulation, the least intrusive policy tool that will accomplish the regulatory purpose should be used. The tools of financial disclosure and mandatory consumer and community advisory committees would seem to be adequate. Existing law was certainly adequate to allow the Attorney General to question a prospective conversion transaction and, if necessary, obtain a court order that would enjoin it The 1996 law gives the Attorney General more time and more flexibility, but it does not necessarily represent a solution to a particularly pressing public interest problem. In the Attorney General’s public files, I saw nothing to suggest that die pre-1997 hospital conversion transactions (which are discussed in this dissertation) received inferior scrutiny or that the public interest was disabused. Unobservable lapses in transactional evaluation may have occurred but if they did, the asset value impact was immaterial. The California Legislature made no extensive fact-findings regarding the public interest in hospital 224 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. conversions. That “billions of dollars” may be at stake in hospital conversions does not necessarily mean that existing laws are inadequate and intense government regulation is required.4 3 Existing law was also adequate to govern the use of conversion proceeds, although the doctrine of cy pres is in need of reform. The 1996 law gives the Attorney General the right to determine how the conversion proceeds should be used. In some instances, especially Good Samaritan Health System and Queen of Angels, the Attorney General’s spending plans are extremely detailed and management of the conversion foundation has too little discretion. In time, the Attorney General’s spending plans may prove to be a burdensome straightjacket to the community’s detriment Moreover, given the plans’ complexities, the Attorney General will have to use a variety of outside experts to effectively monitor compliance at no small cost to the conversion foundations. This too is likely to be burdensome and wasteful. Finally, the Attorney General is supposed to be California’s top legal officer and public prosecutor. His office is staffed with lawyers. It is not staffed with accountants, economists, public health specialists, or men and women with MBAs and relevant hospital management consulting experience, although some of each may be available to him from time to time for a particular task or engagement Assuming California’ s hospital conversion legislation is warranted, does the Attorney General have the “right stuff” and the “right staff” for the job? This is, I believe, an important but unplumbed question.4 4 225 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Chapter 5 1 See Special Issue, “Hospital & H ealth Plan Conversions,’ * 16(2) Health Affairs (March/April 1997). 2 See Malcolm Gladwell, The Tipping Point: How Little Things C a n Make a Big Difference (Boston: Little, Brow n and Company, 2000). 3 See Stanley S. Surrey and Paul R . M cD aniel, Tax Expenditures (Cambridge, M A : Harvard University Press, 1985), ch. 4. 4 See Dieter Bds, Privatization: A Theoretical Treatment (Oxford: Clarendon Press, 1991), and John D. Donahue, The Privatization Decision (New York: Basic B ooks, Inc., 1989). 5 Calif. Corp. Code § 5914 etseq. (Deering’s 2000). 6 Calif. Corp. Code § 5911 (Deering’ s 2000). 7 Calif. Corp. Code §5913 (Deering’ s 2 000). 8 Calif. Corp. Code §5142 (Deering’s 2000). 9 Calif. Corp. Code § 5914 et seq. (Deering’ s 2000). 1 0 For a discussion of government or bureaucratic failure, see David B . Johnson, Public Choice: An Introduction to the New Political Economy (Mountain View, C A : Mayfield Publishing Company, 1991). 1 1 See, e.g., Mark Krause, “ “First, D o N o Harm ”: An Analysis of the Nonprofit Hospital Sales Acts,” 45 U C L A Law Review 503 (D ecem ber 1997). 1 2 Buyer’ s remorse is not uncommon. See, e.g., Steven N . Kaplan and Michael W . Weisbach, “The Success of Acquisitions: Evidence from Divestitures,” 47(1) Journal o f Finance 107 -138 (March 1992); N . Nejat Seyhun, “D o Bidder Managers Knowingly Pay Too Much for Target Firms?” 63(4) Journal o f Business 439 - 464 (October 1990); Randall Motck, Andrei Shleifcr, and Robert W . V ishny, “Do M anagerial Objectives Drive Bad Acquisitions?” 45(1) Journal o f Finance 31 - 48 (M arch 1990); and B ernard S. Black, “Bidder Overpayment in Takeovers,” 41 Stanford Law Review 597 (February 1 9 8 9 ). 226 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 3 Calif. Corp. Code § S913 (Deering’ s 2000). 1 4 See 1 1 California Code of Regulations § 999.5{eX 3 X FX 1 9 9 8 ). 1 5 The official press release merely states that Sharp Hospitals of San Diego had voluntarily agreed to terminate its proposed joint venture with Cotumbia/HCA. See California Attorney General Press Release No. 97-017 (February 21, 1997). Privately, the Attorney General was concerned about die necessity of a sale and the hospital’ s valuation. 1 6 M ark Krause, “ “First, Do No H arm ”: An Analysis of the Nonprofit Hospital Sales A cts,” 45 U C L A Law Review 503 (December 1997). 1 7 See, e.g., David G. Luenberger, Investment Science (N ew York: Oxford University Press, 1 998), ch. 1 2. 1 8 The Attorney General insisted upon a “put” so that the conversion foundation can force Columbia/HCA to purchase its equity interest in the joint venture at any time. 1 9 Calif. Corp. Code, § § 5917,5923 (Deering’s 2000). 2 0 Malvern J. Gross, Richard F . Larkin, Roger S. Bruttomesso, and John J. McNally, Financial and Accounting Guide for Not-for-Profit Organizations. 5* ed. (New York: John Wiley & Sons, Inc., 1995), p. 351. 2 1 See Calif. Health & Saf. Code § 1 2 7340 (Deering’s 2000). 2 2 See William M . Gentry and John R . Penrod, “ The Tax Benefits of Not-For-Profit H ospitals,” (Cambridge, M A : National B ureau of Economic Research, Working Paper 6435, February 1 9 9 8 ). 2 3 See Tide 5. United States Code, § 552b. 2 4 Jody Freeman, “Privatization: Private Parties, Public Functions and the New Administrative Law ,” 52 Administrative Law Review 813 (Summer 2000). See also Carole Patem an, Participation and Democratic Theory (Cambridge: Cambridge University Press, 1970). 2 5 Calif. Health & Saf. Code § 127340 et seq. (Deering’s 2000). 2 6 Calif. Gov. Code § 12580 (Deering’s 2000). 2 7 Public directorships is an old idea. In fact, when the Union Pacific Railroad was organized in 1862, its federal charter specified that two of die fifteen board members were required to be presidential nominees. See Christopher D. Stone, Where the Law Ends: The Social Control o f Corporate Behavior (New York: Harper & Row, 1975), ch. 1 5 . 227 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2 8 See Special Issue, “ The Com m ercialism Dilemma of the Nonprofit Sector,” 17(2) Journal o f Policy Analysis and Management (Spring 1998). 2 9 See Alice A . Noble, Andrew L Hyams, and Nancy M . Kane, “Charitable Hospital Accountability: A Review and Analysis of Legal and Policy Initiatives,” 26 Journal o f Law, Medicine A Ethics 116 (Summer 1 9 9 8 ). 3 0 See Curt A . Kramer, “Nonprofit Hospitals: A Charitable Cause or Unjustified Tax Subsidy?” 19(3) T h e Exempt Organization Tax Review 341 - 374 (March 1998). See also Evelyn Brody, “Agents without P rincipals: The Economic Convergence of the Nonprofit and For-Profit Organizational Forms,” 40 New Yor k Law School Law Review 457 - 535 (1996); David A . H ym an, “The Conundrum of Charitability: Reassessing Tax Exemption for H ospitals,” 1 6 American Journal o f Law and Medicine 327 - 380 (1990); and Theodore R _ Mannor, M ark Schlesinger, and Richard W. S m i they, “A New Look at Nonprofits: Health Care Policy in a Competitive Age,” 3 Yale Journal on Regulation 313 - 349 (Spring 1986). 3 1 See D ouglas M . Mancino, “Intermediate Sanctions and Changes in Use are Factors in Conversions of Tax Status,” 9(2) Journal o f Taxation o f Exempt Organizations 58 - 7 1 (September/October 1997). 3 2 Revenue Ruling 56-185,1956-1 Cumulative Bulletin 202. 3 3 Frances R . Hill and Barbara L. K irschten. Federal and State Taxation o f Exempt Organizations (New Y ork: Warren, Gorham & Lam ont, 1998), 13.02. 3 4 Revenue Ruling 69-545,1969-2 Cumulative Bulletin 11 7 . 3 3 Revenue Ruling 83-157,1983-2 Cumulative Bulletin 94. 3 6 Announcement 92-83,1992-22 Internal Revenue Bulletin 59. 3 7 California data may be found on the website of the Office of Statewide Health Planning & Development: w w w oshodcahw netoov. 38 AICPA Audit and Accounting G uide, Health Care Organizations (New York: Am erican Institute of Certified Public Accountants, 1997), J 10.03 3 9 Ibid., 110.20. 4 0 See Cedars o f Lebanon Hospital et al. v. County o f Los Angeles, 35 Cal. 2d 729 (1950). 4 1 See Calif. Corp. Code § 5930 (Deering’ s 2001). 4 2 Robert E . Litan and William D . Nordhaus, Reforming Federal Regulation (New H aven: Yale University Press, 1983), ch. 2. 228 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4 3 Eleanor H am burger, Jeanne Finberg, and Leticia Alcantar, “ The Pot of Gold; Monitoring Health Care Conversions Can Yield Billions of Dollars for Health Care," Clearinghouse Review 473 - 504 (August - September 1995). 4 4 For the view that the professional orientation of lawyers may make them unsuitable to be program administrators, see James Q. Wilson, e rL , T h e Politics o f Regulations (New York: Basic Books, Inc., 1980), ch. 1 0 . 229 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. B iblio g raph y Abbott, Langer & Associates. 1998. Compensation in nonprofit organizations. 9t h ed. Crete, IL: Abbot, Langer & Associates. Allen, R. G. D. 1962. Mathematical analysis fo r economists. 1 “ ed., 1938. Reprinted 1962. London: Macmillan & Co. -------------- . 1967. Macro-economic theory: A mathematical treatment. London: Macmillan & Co. Altman, Edward I. 1993. 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California Department of Corporations News Releases. Available online at www.coro.ca.oov. Canning, John B. 1929. The economics o f accountancy. New York: The Ronald Press. Cedars o f Lebanon Hospital et al. v. County o f Los Angeles, 35 CaL2A129 {\95Q). Cede & Co. and Cinerama v . Technicolor, Civil Action No. 7129, Delaware Court of Chancery, 1990 Del. Ch. LEXIS 259 (October 19,1990). Cheng, C. S. Agnes, Chao-Shin Liu, and Thomas F. Schaefer. 1997. The value-relevance of SFAS No. 95 cash flows from operations as assessed by security market effects. 11(3) Accounting Horizons 1 -1 5 (September). Citizens fo r Public Accountability v . Desert Health Systems et al., 198 Cal. App. 3d 1067 (CL App. 1988). Clark, John J., Thomas J. Hindelang, and Robert E. Pritchard (1984). Capital budgeting. Englewood Cliffs, NJ: Prendce-HalL Inc. Claxton, Gary, Judith Feder, David Shactman, and Stuart Altman. 1997. 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Copeland, Thomas E., and J. Fred Weston. 1988. Financial theory and corporate policy. 3rf ed. Reading, MA: Addison-Wesley Publishing Company. Coverdale, John F. 1998. Preventing insider misappropriation of not-for-profit health care provider assets: A Federal tax law prescription. 73 Washington Law Review 1 (January/ Crimm, Nina J. 1999. Why all is not quiet on the “home front” for charitable organizations. 29(1) New Mexico Law Review 1 -3 0 (Winter). Cumulative Bulletin o f the Internal Revenue Service. 19S6. Revenue ruling 56-185 (1956- 1). Washington, DC: U.S. Government Printing Office. -------------- . 1959. Revenue ruling 59-60 (1959-1). Washington, DC: U.S. Government Printing Office. --------------. 1969. Revenue ruling 69-545 (1969-2). Washington, DC: U.S. Government Printing Office. -------------- . 1983. Revenue ruling 83-157 (1983-2). Washington, DC: U.S. Government Printing Office. Cutler, David M., ed. 2000. 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St. John s General Hospital et al., 875 F.2d 1064 (3r d Cir. 1989). Unland, James J. 1993. The valuation o f hospitals & medical centers. Chicago: Probus Publishing Company. Valentine, Steven T. 1990. Warning signs and the turnaround plan for the financially distressed hopsital. / 7(2) Topics in Health Care Financing 1-7 (Winter). Van de Kamp v . Gumbiner, 221 Cal.App.3d 1260 (C t App. 1990). Veasey, E. Norman. 1997. The defining tension in corporate governance in America. 52(2) Business Lawyer 393 - 406 (February). Volunteer Trustees Foundation for Research and Education. 19%. When your community hospital goes up fo r sale. Washington, DC: Volunteer Trustees Foundation for Research and Education. Walz v. Tax Commission, 397 U.S. 664 (1970). Weimer, David L., and Aidan R. Vining. 1992. Policy analysis: Concepts and practice 2n d ed. Englewood Cliffs, NJ: Prentice Hall. Weitzman, Martin L. 2001. Gamma discounting. 91(1) American Economic Review 260 -271 (March). Weston, J. Fred, Kwang S. Chung, and Juan A. Siu. 1998. Takeovers, restructuring, and corporate governance. 2n d ed. Upper Saddle River, NJ: Prentice Hall. Whaley, J. Patrick, ed. 2000. Advising California nonprofit corporations. 2n d ed. Oakland, CA: Continuing Education of the Bar. 251 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. White, Gerald I., Ashwinpaul C. Sondhi, St Dov Fried. 1998. The analysis and use o f financial statements. 2o d ed. New York: John Wiley & Sons. Wilkins, Aaron S., and Peter D. Jacobson. 1998. Fiduciary responsibilities in nonprofit health care conversions. 23(1) Health Care Management Review 77 - 90 (Winter). Williams, John Burr. 1938. The theory o f investment value. Cambridge, MA: Harvard University Press. Wilson, James Q. 1980. The politics o f regulation. New York: Basic Books, Inc. Wilson, J. Holton, and Barry Keating. 1990. Business forecasting. Homewood, IL: Richard D. Irwin, Inc. Winston, Wayne L. 1996. Simulation modeling using @risk. Belmont, CA: Wadsworth Publishing Company. Witman, Stephen V., and Richard A. Speizman. 1999. Valuation issues pertaining to not- for-profit health care. 3(1) Valuation Strategies 20 (Sept/Oct.). Wood, Miriam M., ed. 199S. Nonprofit boards and leadership: Cases on governance, change, and board-staff dynamics. San Francisco: Jossey-Bass Publishers. Woolhandler, Steflfie, and David U. Himmelstein. 1997. Costs of care and administration at for-profit and other hospitals in the United States. 336(11) New England Journal o f Medicine 769 - 774 (March 13). Yoffie v. Marlin Hospital District, 19 3 Cal.App.3d 743 (CL App. 1987). Young, David W. 1986. Ownership conversions in health care organizations: Who should benefit? 10(4) Journal o f Health Politics. Policy and Law 765 - 774 (Winter). Zaller, John R. 1992. The nature and origins o f mass opinion. Cambridge: Cambridge University Press. Zumbrun v. University o f Southern California, 25 Cal.App.3d 1 (C t App. 1972). 252 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A ppendices Appendix A: Technical Appendix to Chapter 1 Appendix B: Technical Appendix to Chapter 2 Appendix C: Technical Appendix to Chapter 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Appendix A Technical Appendix to Chapter 1: Mechanics and Legal Issues Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Technical Appendix to Chapter 1 Mechanics and Legal Issues A.1 Basic Mechanics It is necessary to have some familiarity with the basic mechanics of hospital conversions, of which there are three basic kinds: a conversion in place, a purchase and sale o f assets, and a merger.' Although the mechanics and end results are somewhat different, in each case a charitable “set-aside” is legally required; i.e., the sales proceeds must be either retained by the selling nonprofit hospital corporation or transferred to another charitable corporation. Whether the sales proceeds are retained by the selling nonprofit hospital corporation or transferred to another charitable corporation, the State Attorney General must approve the charitable use to which the sales proceeds will be put Even with a charitable “set-aside,” state law must allow the conversion transaction to take place.2 In practice, almost all hospital conversions have been structured as a purchase and sale o f assets (or asset sale) transaction and relatively few, if any, hospital conversion transactions have been structured as a conversion in place or as a merger.3 In an asset sale transaction, the consideration may be cash or securities, including an equity interest in the acquiring “for-profit” corporation. Thus, a selling nonprofit hospital corporation may transfer all of its hospital operating assets (both real and personal property) to a “for-profit” 255 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. corporation in exchange for any combination of cash, promissory notes, or other securities, including a “joint venture” equity interest in the “for-profit” purchaser. The mechanics and legal issues attendant to most hospital conversions are outlined in the following two sections. A.2 Sale of Assets Under the first method, a purchase and sale o f assets (or asset sale), a non-profit hospital may sell its operating assets (including real property) to a “for-profit” hospital corporation in exchange for cash, securities (e.g., an interest-bearing promissory note, either secured or unsecured), or both. An “all cash” transaction for a principal sum equal to the hospital’s net assets is to be preferred. Immediately after the sale, the selling non profit corporation will cease to function as an operating hospital and commence to function as a tax-exempt charitable or social welfare organization, and the non-profit corporation will use income (or principal) derived from the hospital’s sales proceeds for charitable or social welfare purposes. The following scenario illustrates the core issues: 1 . Assume a “nonprofit” hospital has $5x in cash and marketable securities, $75x in operating assets (e.g., hospital plant and equipment), and $45x in liabilities. Assume further that these figures represent “fair market value” so that the hospital’s fair market value “net worth” or equity (assets minus liabilities) is $35x. 256 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2. Assume an “all cash” sale. Since the “for-profit” acquiring hospital only wants die operating assets (i.e., plant and equipment), it will have to pay the selling nonprofit corporation $75x cash (the fair market value of the plant and equipment). The selling nonprofit corporation will retain its cash of $5x. 3. After the asset sale, die selling nonprofit corporation will have $80x (SSx + S7Sx) in cash, of which $45x will be used to pay-off all liabilities. With all liabilities paid, the seller will have $35x in cash available for charitable or social welfare uses. The $35x is equal to selling corporation’s net worth or equity. 4. Alternatively, the “for-profit” purchaser can assume the seller’s liabilities and pay S30x cash ($75x - $45x) to the seller. The result will be the same: the selling non-profit hospital will have $35x cash ($5x + S30x) available for charitable or social welfare uses. 5. The selling corporation will remain in existence and use the $35x cash for attorney general-approved charitable or social welfare purposes. Alternatively, and with the approval of the attorney general, die selling corporation may transfer the $35x cash to a new or existing charitable corporation and then dissolve. But what if the sale is not “all cash?” If the economic consideration includes a promissory note, the interest rate and other terms of the note must be considered.4 If the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. note is unsecured, the directors or trustees of the selling non-profit hospital should definitely balk because o f die possibility of default: even secured notes can pose valuation problems if die underlying security (e.g., the selling hospital's assets) is not readily marketable or realizable (i.e., convertible to cash). In some instances, the “public” parent of the purchasing subsidiary may be required to guarantee the purchaser’s obligation to the selling non-profit hospital corporation. In asset purchase transactions it is typical for the seller to give covenants and warranties concerning its assets and liabilities, the breach of which can require an indemnification payment or stipulated purchase price adjustment These adjustments could significandy reduce the amount of asset compensation that is ultimately received by the selling non-profit hospital corporation. For example, if the outstanding balance of the buyer’s promissory note is $50x, a purchase price adjustment could result in the abatement of a portion of the remaining (principal) balance. These covenants and warranties may be given short shrift by the selling non-profit hospital’s officers, directors, and trustees (and by regulatory authorities as well) because the potential cash flow detriment to the selling charitable corporation may not be readily apparent during the course of transactional review. In asset purchase transactions, there is a legal transfer of the non-profit hospital’s operating assets (both real and personal property) to the “for-profit” acquiring hospital corporation, coupled with an agreement that some or all of the non-profit hospital’s physician and non-physician employees will become employees of the “for-profit” hospital. Often no major physical asset or personnel changes occur, but subsequently the acquiring “for-profit” corporation may dispose of unwanted or surplus assets and terminate 258 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the employment of unnecessary hospital personnel. The acquiring corporation’s obligation to retain hospital personnel may be a matter of contractual concern to key hospital personnel. Hidden asset values may be “buried” in overlooked intangible assets and thus neglected by the seller. Intangible assets typically include a workforce in place (i.e., it costs money to hire and train suitable personnel and recruit physicians and other personal service providers), business operating systems (i.e., it costs money to write and produce personnel and systems manuals for hospital employees), a prospective customer base (i.e., marketing healthcare services requires time and money), contracts and relationships with suppliers (i.e., besides the cost of negotiating new contracts, a new business would have to learn who offers quality services and products), and licenses and permits to operate a hospital (i.e., expensive and time consuming to obtain).5 These values are not shown on hospital balance sheets. In some cases, directors and officers of the selling non-profit hospital corporation may become directors and officers of the acquiring “for-profit” hospital corporation with lucrative compensation arrangements, including stock options. California’s Attorney General alleged that this occurred in the FHP case. A concern, therefore, is that hospital conversions may present unscrupulous directors, trustees, and officers o f “non-profit” hospitals with an incentive to under-value hospital assets in exchange for favorable post acquisition compensation arrangements. With the exception of Riverside Community Hospital, the hospital transactions described in Table 2, Chapter 1, were conversions of this kind and in each case the sole consideration was a lump-sum cash payment The conversion of Riverside Community 259 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hospital entailed die formation of a joint venture arrangement of the kind described in the following section. A.3 Joint Venture Formation In some cases, die non-profit hospital corporation may contribute or transfer its operating assets (e.g., real and personal property) to a newly formed “for-profit” limited liability company (LLC) in exchange for some combination of cash, promissory notes, and an equity or partnership interest in the LLC.6 The result is a hospital joint venture or partnership with the acquiring “for-profit” hospital corporation. This has been the pattern followed by Columbia/HCA Healthcare in many of its acquisition endeavors,7 and the subject of Internal Revenue Service scrutiny because of die possibility that the selling non profit hospital might be unable to receive distributions from the LLC for tax-exempt purposes.' Riverside Community Hospital (Table 2, Chapter 1) is an example o f a conversion of this kind. The following scenario illustrates the critical issues: 1 . Assume a “nonprofit” hospital has $5x in cash and marketable securities, $75x in operating assets (e.g., plant and equipment), and $45x in liabilities. Assume further that these figures represent “fair market value” so that the hospital’s fair market value “net worth” or equity (assets minus liabilities) is $35x. Suppose the nonprofit hospital is willing to enter into a 50:50 joint venture with Columbia/HCA. 260 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2. Let Columbia/HCA create Newco, a Delaware LLC, and transfer cash or other assets having a value of $35x to the LLC. Immediately thereafter, let the selling nonprofit hospital transfer its operating assets (word) $75x) to the LLC and let the LLC assume the hospital's liabilities of $45x. 3. Immediately thereafter, the LLC will have received $35x in value from Columbia/HCA and $35x in value ($75x - $4Sx) from the contributing nonprofit hospital. For financial accounting purposes, each partner’s capital account will reflect $35x and thus there will exist a 50:50 partnership or joint venture. 4. The selling hospital, now a “partner7 ’ in the LLC, will become a charitable or social welfare organization and use distributions from the LLC to further its tax-exempt purposes. But what if there are no distributions? In the absence of an immediate cash distribution from the LLC, what assurance is there that the passive tax-exempt partner will ever receive anything of value from the LLC? If no distributions are forthcoming, should the tax-exempt partner have a “p u r to sell its partnership interest to Columbia/HCA for a specified value? 5. Alternatively, suppose Columbia/HCA contributes $25x in cash to the LLC and the nonprofit hospital contributes $35x in net assets to the LLC so that upon formation total partnership capital is $60x. Next, suppose the LLC distributes SlOx cash to the selling nonprofit Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospital. After the distribution, Columbia’s capital account will be $25x and the selling hospital’s capital account will be $25 x ($35x - SlOx). There will be a 50:30 joint venture or partnership. In exchange, for hospital assets worth $35x, die former nonprofit hospital will have received SlOx in cash and a LLC interest worth $25x. (Instead of SlOx cash, the LLC could have distributed a promissory note worth SlOx to the selling hospital with the same partnership accounting result) 6. The selling corporation will remain in existence and use its $35x in assets for attorney general-approved charitable or social welfare purposes. Alternatively, and with the approval of the attorney general, the selling corporation may transfer its $35x in assets to a new or existing charitable corporation and then dissolve. The fundamental principal is that the amount of cash, the value of any promissory notes, and the value of any equity or partnership interest received by the selling non-profit hospital must be equal to the value of the transferred hospital assets at the time of the sale or transfer or partnership creation. The value of a security or promissory note depends upon the obligation’s term, interest rate, credit worthiness, negotiability, and guarantees, if any. In the absence of a parent company’s guarantee, a note issued by a newly formed LLC can be worth significantly less than face value because the LLC may not have the ability to service the debt (i.e., pay principal and interest when payments are due). 262 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Consequently, if the selling non-profit hospital receives a promissory note, there is always a risk of nonpayment Equity or partnership interests in newly formed LLCs present controversial valuation problems. In some cases, the non-profit seller may be a ‘ ‘minority” equity member or partner, and thus in no position to dictate how the LLC will distribute its “free cash flows.” More important die non-profit seller’s LLC interest is unlikely to be readily marketable. Unless die non-profit seller has the unconditional right to sell or “put” its equity interest in the LLC to the “for-profit” LLC member (in exchange for cash payments), the non-profit seller may be incapable of realizing the full value of its assets. As one commentator has remarked, from a fiduciary point of view “careful consideration must be given to the development of a plan for monetization of the equity over time.” 9 Non-cash sale transactions are thus fraught with economic difficulties. Two years ago, the United States Tax Court expressed dissatisfaction with joint ventures involving tax-exempt hospitals. In Redlands Surgical Services v. Commissioner, 113 T.C. 47 (1999), the Tax Court agreed with the Internal Revenue Service that a California nonprofit public benefit hospital corporation was not being operated exclusively for charitable purposes because the corporation was a party to a joint venture agreement that gave too much control and too much profit to the “for-profit” partner. The court noted that nothing in the joint venture or partnership agreement obligated the joint venture to put charitable purposes ahead of economic objectives. Since the Tax Court’s holding was recently affirmed by the United States Court of Appeals for the Ninth Circuit,1 0 there may be fewer joint venture hospital conversions in California and other western states. 263 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A.4 Tax Consequences In asset sale transactions, the selling nonprofit hospital corporation is not required to pay federal income tax on any portion of die hospital sales proceeds because of a specific exemption in the Internal Revenue Code.1 1 Although charitable corporations are required to pay income tax on “unrelated business” taxable income, g ain from die sale of operating assets is not deemed to be “unrelated business” taxable income and, accordingly, the gain is exempt from tax. If Congress were to change the tax law to include gain from the sale of operating assets within the definition of “unrelated business” taxable income, there might be fewer conversion transactions because the income tax burden might severely dampen the selling nonprofit hospital corporation’s enthusiasm for the conversion transaction. This is another empirical question. In an asset sale transaction, for income tax (depreciation expense) purposes the “for-profit” purchasing corporation must allocate the hospital’s purchase price to the hospital’s real and personal property.1 2 Since “goodwill” is now amortizable for income tax purposes over a 15-year period, amounts paid for a “workforce in place” and other hospital business intangibles will be deductible to the purchasing corporation.1 3 Thus, the full purchase price will be tax deductible even if die “for-profit” purchaser does pay too much money for the assets of a nonprofit hospital. Before 1993, amounts paid for intangibles were not amortizable for income tax purposes and thus a purchaser obtained no tax benefit. 264 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Appendix A 1 See generally D ouglas M . Mancino, “Exempt Entities: Joint Ventures, Virtual Mergers and Conversions of Status,” 50 Major Tax Planning 8-1 - 8-62 (1998). 2 State law, of course, must allow the conversion transaction to take place. See generally Theodore C. Falk, “ Converting From A Nonprofit To A B usiness Corporation,” 23(4) University o f San Francisco Law Review 443 - 472 (Summer 1 9 8 9 ). Conversions involving health maintenance organizations or health service plans exhibit different legal structures and hence they are not within the scope of this technical appendix. 3 See Stephen T. Braun, “Acquisitions of Exempt Hospitals by Investor-Owned Companies,” in Forum on Health L aw of the American Bar Association, Health Care Mergers and Acquisitions (Chicago: Am erican Bar Association, Monograph 4, December 1 9 9 S ). 4 In sophisticated transactions, there may be an “earn-out” or contingent purchase price. If the “for-profit” purchaser is willing to pay a price that is contingent upon the acquired assets’ future earnings, special valuation and legal issues will arise. 5 For a definition of business intangibles, see Internal Revenue C ode of 1986, § 197(d). 6 Although LLCs are corporations for state law purposes, they are frequently classified as partnerships for federal income tax law purposes. Partnership status is desirable because there is no “double taxation” of income or profits. 7 Stephen T. Braun, “Acquisition of Exempt Hospitals by Investor-Owned Companies," in Forum on Health Law of the American Bar Association, Health C are Mergers and Acquisitions (Chicago: Am erican Bar Association, 1995). 8 In an attempt to lim it the use of die LLC concept, the Internal Revenue Service issued Revenue Ruling 98-15, 1 9 9 8 -1 Cumulative Bulletin 718. The technical incom e aspects of the ruling are discussed in D ouglas M . Mancino, “New Ruling Provides G uidance, Raises Questions for Joint Ventures Involving Exem pt Organizations," 88(5) Journal o f Taxation 294 - 298 (May 1998). 9 Douglas M . M ancino, “Converting the Status of Exem pt Hospitals and Health Care Organizations," 9 Journal o f Taxation ofExempt Organizations 8-27 (July/August 1997). 1 0 242 FJd 904 (9* C ir. 2001). 265 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 1 Internal Revenue Code of 1986, § 5l2(bX5). For a discussion, see Douglas M. Mancino, “Exempt Entities: Joint Ventures, Virtual Mergers and Conversions of Status, 50 Mayor Tax Planning 8-1 - 8-62 (1998). 1 2 See Internal Revenue Code of 1986, § 1 0 6 0 . 1 3 See Internal Revenue Code of 1986, § 1 9 7 . Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Appendix B Technical Appendix to Chapter 2: Hospital Valuations 267 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Technical Appendix to Chapter 2 Hospital Valuations BA Case Study Document Sources This technical appendix presents the valuation results of several hospital conversion case studies from the California Attorney General’s official transaction files, portions of which are “public records” open to inspection under the provisions of the California Public Records A ct Some of die files document hospital conversions that occurred after January 1, 1997, the effective date of California’s hospital conversion legislation; the remaining files document pre-1997 hospital conversion transactions. B.2 Overview Contemporary business enterprise valuation starts with a core proposition of modem financial economics: the value of an income-producing asset, including a going- concern hospital enterprise, is the present value of the asset’s future income or cash receipts.1 In other words, the “value of any property, or rights to wealth, is its value as a source o f income and is found by discounting that expected [cash] income.” 2 The fundamental problem is how to reduce this core proposition to practice.3 268 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In theory, the discounted cash flow (DCF) technique is the “gold standard” or “first-best” approach for ascertaining business enterprise value, the cardinal assumption being that die present value of estimated future cash flows is implicit in all market prices.4 The basic DCF model requires the following three components: (1) an estimate of the enterprise’s net or free cash flows (i.e., cash available for distribution to long-term creditors and equity investors) for a suitable projection period (typically five years), (2) an estimate of the enterprise’s “terminal value,” and (3) a suitable discount rate, usually the enterprise’s weighted average cost of capital. Unfortunately, depending upon cash flow and discount rate assumptions, the DCF model is capable of generating a wide range of valuation estimates and disagreements/ Earnings (EBITDA) multipliers and “comparables” derived from previous transactions or public market data constitute “second-best” valuation approaches but useful “reality checks” nonetheless. Contemporary DCF methodology uses standard annuity-based formulas, the mathematics o f which may be either discrete or continuous. The following sections present the more important valuation principles and formulas. 8,3 Discrete Time Modeling If the interest rate (/) remains constant over time and if the periodic income or cash receipts are r,, rh ... rm then the capital value of an income-producing asset (V) is simply: (1) 269 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In practice, the periodic income (cash) receipts are contingent annual receipts; i.e., the income measurement period is the calendar or fiscal year. The assumption of a constant interest rale, although not technically correct, simplifies the algebra.6 If the periodic or annual income receipts are assumed to remain constant or fixed (that is, if it is assumed that r, = r2 ... = r«), then equation (1) reduces to the familiar formula for the present value of an ordinary annuity: The assumption underlying an ordinary annuity is that fixed payments are made at the end of each period (year) for n periods (years).7 If the constant or fixed payments will continue forever (i.e., n -» o o ), equation (2) yields the familiar formula for a perpetuity: Examples of perpetuities include dividends on nonredeemable preferred stock and British “consols,” a perpetual interest-bearing bond first issued by the British government in 1752 under Chancellor of the Exchequer Henry Pelham.* Because the receipt of constant or fixed periodic or annual payments is rare, it is useful to allow the periodic or annual receipts to grow in value at a constant rate, g. When this occurs the result is the so-called constant growth annuity: (2) (3) 1 r ( l + & )'-' r t r(l + g ) ' < t r(l + g ) - (l + iy (1 + 0 ' (1 + 0 2 0 + 0* (4) 270 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Although equation (4) looks formidable, it simplifies to (5) which, if the periodic payments are deemed to continue forever, converges to (6) but only if i > g. Equation (6) is featured in most contemporary textbooks on finance and investments because it is used to value “growth perpetuities” such as common stocks and other investment opportunities, including business enterprises.9 The reader should observe that if g = 0, equation (5) reduces to equation (2), and equation (6) reduces to equation (3). Most business valuation practitioners use a combination of these equations to value a business enterprise. The first step in using the DCF model is to ascertain the present value of an enterprise’s expected free cash flows for a suitable time horizon, typically five years. (In practice, it is difficult to project or estimate free cash flows beyond ten years and, in fret, most practitioners stop at five years.1 0 ) These contingent cash flows may be designated r,. r:. ... r5 Hence their present value is: Rarely, if ever, would there be equal contingent cash flows such that r, = r2 ... = rs. (7) 271 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The second step is to estimate the “terminal value” of the business enterprise; i.e., the present value of all anticipated free cash flows beyond the projection period. This means die practitioner must determine the present value of fiee cash flows for the periods 6 , 7 , oo. To accomplish this task, a practitioner would use equation (6) and discount the result by five years. Consequently, in the light of the customary inability to project free cash flows beyond five years, the complete valuation equation would be: ! - 1 'V,(i+g)5'1 B E v= Y -5 — +f r> (l+gY-- = y r-ro+o' is <i+o' s?a+<y o+o i~ g (8) If the forecast period is shorter or longer than five years, appropriate adjustments to the indices of summation would have to be made. To reiterate, equation (8) consists of two components. The first component is merely the present value of the enterprise’s estimated or projected cash flows for the first five years; the second component is the present value of the enterprise's cash flows for the remainder of its assumed infinite life; i.e., the period [6. oo]. The second component, which reflects the enterprise’s so-called terminal value assumption, is merely the value of a constant growth perpetuity that is discounted by five years. The critical assumption is that after the fifth year all cash flows will grow at a constant rate, g. (To avoid cumbersome algebra, I have not used the midyear discounting adjustment1 1 Rather, the underlying assumption is that all cash flows occur at the end of each year.) Equation (8) assumes that after five years the enterprise’s cash flows will continue to grow at a constant rate, g. This, rather rigid and possibly unrealistic, assumption can cause large swings in the value o f a business enterprise for seemingly small changes in g. 272 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Consequently, the valuation analyst should always perform a sensitivity analysis to discern the impact of changes in the discount rate (i) and the growth rate (g) on business enterprise value. None of the professional valuation reports reviewed in this dissertation contained appropriate sensitivity tables or matrices, and it appears that the California Attorney General’s office failed to request diem. Discrete multi-stage equity or investment models do exist to overcome the limitations of the constant growth assumption, but they are generally quite cumbersome to use. Some of these models allow for early periods of high growth followed by later periods of lower growth.1 2 Because of the substantial damping effect of the discount factor (i.e., as r increases the present value factor decreases), it is highly unlikely that more sophisticated models are able to enhance the business enterprise valuation process. Perhaps this explains why practitioners tend to favor equation (8): It is easy to use. Electronic spreadsheets such as Lotus and Excel, with their built-in present value functions, have largely eclipsed the algebra of business valuation reports. Readers, however, need to understand the basic assumptions of the diverse annuity models so that they can determine for themselves the reasonableness of the models’ results. Most valuation reports contain spreadsheets without any formulas or model specifications. This is unfortunate because it tends to leave the reader with little or no understanding of the practitioner’ s annuity toolbox, and virtually no ability to either check the mathematical results or ask pertinent “what if... ” questions. 273 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. B.4 Continuous-Time Modeling Continuous-time financial mathematics may offer a useful alternative. In continuous-time financial economics, suppose the cash flow (cash receipts) at any time is given by f(t). Then the present value of the cash flows (and hence the value of die asset or business enterprise in question) is given by die definite integral where i denotes the appropriate discount rate (the investor’s desired rate of return or project hurdle rate) and n denotes the duration of the cash flows.1 3 The discount rate, /, is assumed to be fixed but it can, of course, vary over time.1 4 Continuous-time analogs of discrete annuity models appear in some finance and economics textbooks.1 5 The problem is how to specify or determine the cash flow function, fit). Depending upon the data, the function may be linear, quadratic, exponential, or even sinusoidal. Sinusoidal models have the advantage of being able to capture cyclic or oscillatory behavior in a business enterprise’s cash flows and they can exhibit increasing or decreasing growth.1 6 Although the law of diminishing returns suggests that an income- producing asset’s cash flow will grow or increase over time but at a decreasing rate of growth (Le., the law suggests that f( t) > 0 but f ’ (t) < 0), a variety of continuous functions can be used as long as there is empirical support for a particular function’s use and the function is integrable. The range of integration represents the duration of the cash flows. It can be [0. n] or [0. ao], but in the case of a “going concern” it is the usual practice to let n approach ao so that the indefinite integral becomes die Laplace transform of/ft). (9) o 274 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The exponential growth model, f(t) = As* is widely used because, for die parameters k > 0 and i > g, it leads to the following elementary re su lt1 7 » > Value (V) = f(ke* )e~*dt = ------ . (10) i i-g Equation (10) is, of course, the continuous-time analog of equation (6). The initial value, may reflect management’s first year post-acquisition cash flow forecast or it may reflect historic cash flow data; e.g., the average (mean) of the enterprise’s cash flows for the five year period immediately preceding the acquisition. The objection to equation (10) is the same as the objection to equation (6): it is the constant growth rate assumption, g. To reduce the valuation theory suggested by equation (9) to practice, I will use the method of least squares to derive simple linear time series cash flow functions for several hospitals from the available financial data.1 1 The derivation of the cash flow function, fft), from historical or projected data is necessarily an exercise in mechanical time series forecasting and no attempt will be made to offer an explanatory or causal model. Although there is a risk of careless or thoughtless extrapolation, a practical and useful assumption is that today’s cash flows depend upon yesterday’s cash flows and it is unnecessary to specify any causal factors. Thus, simple time series linear regression (i.e., forecasting cash flows as a linear function of time) using the elementary method of least squares should be satisfactory.1 9 Although more sophisticated univariate time series forecasting techniques are available, especially ARIMA (autogressive, integrated, moving average) models, these techniques require lengthy data series (i.e., generally more than 30 observations in time). 275 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. B.S Case Studies on Hospital Valuation For DCF business enterprise valuation purposes, practitioners commonly use detailed income and cash flow statements for a period of five or more years immediately prior to the required valuation date, coupled with projections of estimated future cash flows for a limited period of time following the acquisition.2 0 Unfortunately, the Attorney General's official transaction files do not necessarily contain “textbook” quality financial statements, projections, or forecasts. In many cases, the available financial information was cursory at best Some transaction files contained financial statements prepared by the hospital’s independent accountants; others did not Some transaction files contained projections of future cash flows prepared by hospital management or investment bankers; others did not The valuation reports disclosed few assumptions to the reader. Consequently, for valuation comparison and replication purposes, I merely used the available information that was at hand. B .5.1 G ood S a m a r it a n H e a l t h Sy s t e m In December 1995, the nonprofit public benefit Good Samaritan Health System located in Santa Clara County, California agreed to sell three hospitals and their affiliates, including the flagship Good Samaritan Hospital of Santa Clara Valley, to Natomi Hospital of California, Inc., a newly formed “for-profit” affiliate of Columbia/HCA, for SI65 million cash plus an amount to cover certain post-closing adjustments and contingencies. The transaction closed the following year (1996), and the adjusted purchase price was approximately $176.5 million.2 1 276 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In October 1995, the board of directors retained the services o f Shattuck Hammond Partners to value the health system’s three hospitals. According to the Shattuck Hammond valuation report, die valuation range for die hospitals (excluding the non-hospital affiliates) was between SI40 million and $160 million: Table 11: Good Samaritan Hospital Range of Valnes M ethod Minimum Value Maximum Value Comparable companies $100 million $150 million Precedent transactions $127 million $190 million D C F $100 million $156 million Source: Shattuck Hammond Partners Inc. The Shattuck Hammond valuation report contains the following financial information for combined hospital operations (excluding affiliates): Table 12: Good Samaritan Financial Data (Abridged) Year EB ITD A Cash Flows from Operations Free Cash Flows Actual 1 9 9 2 $24,843,000 n/a Actual 1 9 9 3 $21,070,000 $5,758,000 Actual 19 9 4 $18,692,000 ($13367,000) Actual 1 9 9 5 ($3,676,000) ($12392,000) Projected 19 9 6 $12,844,000 ($17315,000) ($8,936,000) Projected 1997 $25,945,000 $2,740,000 $6321,000 Projected 1 9 9 8 $39307,000 $16332,000 $14343,000 Projected 1 9 9 9 $39,700,000 $18351,000 $15,644,000 Projected 2000 $40,097,000 $19,741,000 $15,825,000 M ea n $31,578,600 $7,989,800 $8,619,400 (1996-2000 only) Source: Shattuck Hammond Partners Inc. 277 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The first column is Shattuck Hammond’s determination o f actual and projected EBITDA values; the second column reflects actual cash flows from operations in accordance with the accountant’s report (although this is unclear) and projected cash flows from operations; the third column represents Shattuck Hammond’s determination of “free cash flows” for the projection period (1996 through 2000). I calculated the means of each column for the projection period (19% through 2000). The valuation report contains no financial statements from the accountants and thus no reconciliation schedules. In arriving at its DCF range of IS O million - S1S6 million (Table 11, supra), Shattuck Hammond used discount rates of 16 percent, 18 percent, and 20 percent, which Shattuck Hammond determined to be the weighted average cost of capital in the hospital industry. The report contains no valuation mathematics and thus it is difficult to replicate the Shattuck Hammond DCF range of values using the free cash flow information presented in Table 11. For example, using a discount rate of 16 percent and assuming a terminal value cash flow growth rate of S percent, the business enterprise value is only 594,213,600, which is less than the Shattuck Hammond minimum of 5100 million: BEV = j C ^ A ( $ 1 5 ^ 2 S , 000X 1.05X 1. £ ( 1 + .16)' S (1 + 1 6 )' Using the constant growth annuity method and the mean o f the projected free cash flow column from Table 12 ($8,619,400), it is easy to perform a sensitivity analysis: 278 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 13: Good Samaritan Discount and Growth Factor Sensitivity Analysis i= 1 2 % /=14% / = 16% i = 1 8 % 1 % S78 million $66 million $57 million $51 million g = 2% $86 million $72 million $62 million $54 million g = 3% $96 million $78 million $66 million $57 million g-4% $108 million $86 million $72 million $62 million g = 5% $123 million $96 million $78 million $66 million Source: Author’s calculadoos. This table shows that Shattuck Hammond’s DCF range of value ($100 million - $156 million) requires a low discount rate (12 percent or less) coupled with a high terminal value free cash flow growth rate (at least 3 percent). Shattuck Hammond considered the EBITDA multiplier. It did so by determining EBITDAs for eight transactions between 1992 and 1995, and concluding that the average multiplier was 7.8, which it adjusted downward to 4.7 for “small capitalization and illiquidity reasons.” This adjustment is questionable. Using the mean projected EBITDA shown in Table 12 ($31,578,600), die Good Samaritan transaction multiplier is approximately 5.6 ($176.5 million + $31.6 million), which is slightly less than die GAO report’s typical multiple of six but within the GAO report’s range of five to seven. A comment to the Shattuck Hammond report indicates that due to the hospital’s operating losses a lower EBITDA multiplier should be used. I agree, but this is precisely why I used die average or mean EBITDA for several years instead of relying upon the EBITDA calculation for a single year (Le., the year of sale or the immediately preceding year, depending upon the availability of financial data). 279 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Shattuck Hammond also obtained business enterprise value multipliers from the financial data of several publicly traded hospital chains, including Columbia/HCA, Tenet, and OrNda. For example, for die publicly held chains it determined that the average ratio of business enterprise value (market capitalization)- to-padent revenue was 1.9. Shattuck Hammond then adjusted this figure downward to 1.0 for “small capitalization and illiquidity reasons." Unfortunately, a revenue multiplier of 1.0 applied to Good Samaritan’s net patient revenue of approximately $304 million for die year 199S would suggest a value for Good Samaritan of $304 million, an amount that is well beyond the Shattuck Hammond range of values presented in Table 11. A better source of transactional data is probably nonprofit hospital acquisition data from Irving Levin Associates’ Hospital Acquisition Report (4t h ed., 1998), an excerpt from which appears in Table 3, Chapter 2. Good Samaritan’s price-to-revenue ratio of 0.38 ($176.5 million + $304 million) would appear to be low. The table mean for 1996 (0.83) would imply a hospital system value of approximately $252 million. Of greater interest, perhaps, is the price per bed statistic, which Shattuck Hammond did not consider. In the aggregate, Natomi purchased 1,155 licensed beds and paid $152,813 per bed ($176.5 million -< -1,155), which is substantially less than the price per bed statistics shown in Table 3, Chapter 2. Using Irving Levin Associates’ mean price per bed of $253,308 for 1996, Good Samaritan should be worth approximately $292 million ($253,308 x 1,155), and using the median price per bed of $183,146, the hospital system should be worth approximately $211 million. Although the Shattuck Hammond valuation report is problematic in many respects, the adjusted sales price o f approximately $176.5 may not be unreasonable. Although die 280 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. GAO report’s typical multiplier of six would suggest a hospital system value of approximately S189 million (531,578,600 x 6) and the Irving Levin Associates’ statistics would support a hospital system value in excess of $200 million, the DCF sensitivity analysis (Table 13) falls remarkably short of the actual purchase price. According to Shattuck Hammond’s information, the hospital system did lose cash in 1994 and 199S, and it was projected to lose cash in 1996 (Table 12). Consequently, I would be inclined to give greater weight to the DCF approach than to the other valuation approaches. It is easy to derive a reasonable valuation using the following methods and their respective weights: Table-14: Weighted Average of Possible Valuation—Methods Applied to Good Samaritan Method Implicit B E V Weight Final BEV D C F $94 million 0.40 $37 million Purchase price/revenue $270 million 020 $54 million Price per bed $286 million 020 $57 million EBITDA (6) $189 million 020 $38 million Weighted average BEV $186 million Source: Author’ s calculations. I recognize, of course, that I have the benefit of hindsight Nevertheless, valuation is an art, not a science, and it is appropriate to combine forecasts and projections for purposes of arriving at the best estimate o f business enterprise value. Table 1 4 gives greater weight to the DCF method than to competing, secondary methods, and in the light of die actual purchase price of $176.5 million the weighted average is not unreasonable. However, I this remark is subjective and “after the fact” 281 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Since the Shattuck Hammond valuation report contains both historic and projected data (Table IS, below), the method of least squares can be used to obtain valuation results: Table 15: Good Samaritan Cash Flow Functions Year Operating Cash Flows, At) Free Cash Flows, *< /) Actual 1 9 9 3 $5,758,000 n/a Actual 1 9 9 4 ($13,867,000) n/a Actual 1 9 9 S ($12392,000) n/a Projected 19% ($17,315,000 ($8,936,000) Projected 1 9 9 7 $2,740,000 $6321,000 Projected 1 9 9 8 $16,232,000 $14,243,000 Projected 1 9 9 9 $18,551,000 $15,644,000 Projected 2 0 0 0 $19,741,000 $15,825,000 Mean $2,443,500 $8,619,400 Source: Shattuck Hammond Partners Inc. Using the actual and projected “operating cash flows” (presumably prepared from the accountant’s report, although this is not clear), the least square time series equation for the first column is: f(t) = -$17,142,100 + ($4,352,360)1. The slope is positive but the intercept or constant term is negative. Using Shattuck Hammond’s discount rate of 18 percent, the valuation result is: 0 0 BEV = = $39,098400. 0 282 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This figure is substantially less than Shattuck Hammond’s $100 minimum discounted cash flow value for Good Samaritan Hospital. The reason is obvious: die heavy historic and projected cash flow losses for die years 1994, 1995, and 1996. If one compares the two columns in Table 15, one can see by inspection that Shattuck Hammond’s positive free cash flows are comparable to the accountant’s figures (Table 12) but Shattuck Hammond’s negative free cash flows are substantially less. Using Shattuck Hammond’s “free cash flows” (the second column), die resultant least square time series equation is: g(t) = -$9,034,100 + ($5.884,500)t. The slope is also positive and the intercept is negative. Using a discount rate of 18 percent, the valuation result is: BE V = = $131,431,000. 0 The difference in the valuation result, which is due to the smaller negative intercept and the larger slope, is dramatic. The business enterprise value o f approximately $131 million lies well within Shattuck Hammond’s discounted cash flow valuation range of $100 million - $156 million. The inclusion or exclusion of data points can have a dramatic effect on business enterprise valuation. An investor (hospital purchaser) should prefer the function fit) because it incorporates the hospital’s actual history of negative cash flows. To avoid these negative operating cash flows, the purchaser may have to contribute additional capital to the hospital. The investor should want to know this and adjust die purchase price 283 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. accordingly. The tension is that the hospital’s directors would prefer die function g(t) to maximize cash from the sale of die hospital. Which function is “correct?” The problem is that there is no correct function and only additional time will determine whether Columbia/HCA paid too much for Good Samaritan. Since die purchase (nice was approximately $176.5 million, there is a risk that Columbia/HCA paid approximately $45 million too much for the hospital (i.e., $176.5 million - $131.4 million). To use equation (10), suppose k = $8,619,400, which is the average (mean) value of the projected free cash flows for the five year period 1996 - 2000 (Table 15). Using Shattuck Hammond’s minimum discount rate of 16 percent and an assumed long-term cash flow growth rate of 5 percent, the result is: BEV = $8’6 19,400 = $78358,182. 0.16-0.05 This result is substantially less than Shattuck Hammond’s minimum discounted cash flow (DCF) value of $100 million. To increase business enterprise value, one need only discard the projected negative free cash flow for 1996 so that k = $13,008,250, die mean of the free cash flow projections for the years 1997,1998,1999, and 2000. Substituting, the result is: BE Y = $13’°08’250 = $118356,818, 0.16-0.05 which is within Shattuck Hammond’s DCF value range of $100 million - $156 million. This figure, however, does not diminish the risk that Columbia/HCA may have overpaid for the hospital. A post-acquisition cash flow analysis would be very helpful. 284 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. B .5.2 Centinela V a l l e y He a l t h Se rv ic e s In March 19%, die board of directors of Centinela Valley Health Services, Inc., a California nonprofit public benefit corporation, contemplated selling Centinela Hospital Medical Center, a 400-bed general acute care hospital in Inglewood, California, to Summit Hospital Corporation, a wholly owned subsidiary of Oroda HeahhCorp, for approximately S96.8 million as follows: Although the board of directors was aware that several “for-profit” hospital chains might be interested in purchasing the medical center, it solicited purchase proposals from only Columbia/HCA and OrNda. Ultimately, the board approved OrNda’s purchase proposal because of OrNda’s hospital presence in Los Angeles and Orange Counties. The board expected the transaction to close on May 31,19% without any fanfare. During the Attorney General’s review process under the old law, however, a dissident emeritus member of Centinela’s board, who happened to be (me o f die hospital’s founders, complained to the Attorney General about the proposed sale. According to the dissident’s declaration, the decision to sell was not based upon financial distress, die board never retained the services of an outside consultant to validate its decision to sell the hospital, and a Columbia/HCA executive had told the board that an investment banker Gross purchase price Liabilities assumed by purchaser Net purchase price paid to seller S 96,804,221 ( 75.831.421) 20-972.800 Cash paid to non-profit seller Charitable cash on hand Net cash for charitable use S 20,972,800 29.027.200 8 S O - O O O .O O O 285 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. should be used to properly market the hospital. Because of the dissident's complaint to die Attorney General, Centinela’s board was forced to retain the services of an outside valuation consultant Following the Attorney General’s prompt intervention and mandate to retain the services of an outside consultant, die board of directors chose Morgan Stanley & Co. to render a “ fairness opinion.” On April 17, 1996, Morgan Stanley provided a “fairness opinion” and opined that the purchase would be “fair from a financial point of view” to Centinela, but it noted that it did not independently verify the accuracy or the completeness of the financial information it had received from Centinela’s board of directors. Morgan Stanley’s principals also told the Attorney General’s office that Centinela should have retained die services of an investment banker to market the hospital and obtain competitive bids, which the board was reluctant to do. For the purpose of arriving at its fairness opinion, Morgan Stanley used three methods of valuation: a “public market trading analysis” (i.e., the comparable companies approach), an “analysis of selected precedent transactions” {i.e., the comparable transactions method), and the discounted cash flow approach. Morgan Stanley chose to emphasize the discounted cash flow (DCF) approach and it presented two different DCF scenarios: the first was based upon Centinela management’s cash flow projections without adjustments, and the second involved an alteration of hospital management’s projections and a sensitivity analysis. Table 16 {infra) presents the relevant cash flow information for the first scenario (a ten-year period consisting of a five-year historical period followed by a five-year projection period): 286 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 16: Centinela Hospital's Projected Cash Flows Y ear Morgan Stanley’ s EBITDA Estimated Capital Expenditures M organ Stanley’s Free Cash Flows Actual 1 9 9 1 512^99,000 $5,759,000 $6,840,000 Actual 1992 $12,443,000 $4,837,000 $7,606,000 Actual 1 9 9 3 $13,194,000 $7,481,000 $5,713,000 Actual 1994 $11,480,000 $7,695,000 $3,785,000 Actual 1 9 9 S $14,135,000 $6,236,000 $7,899,000 Projected 19% $14,839,000 $7,027,000 $7,812,000 Projected 1997 $14,756,000 57,268,000 $7,488,000 Projected 1998 $14,356,000 $7,516,000 $6,840,000 Projected 1999 $14,145,000 $7,771,000 $6,374,000 Projected 2000 $13,842,000 $8,034,000 $5,808,000 Column Mean S13.578.900 S6.962.400 $6.616.500 Source: Morgan Stanley’s Fairness Opinion. Morgan Stanley’s EBITDA column is supposed to represent cash flows from hospital operating activities. Unfortunately, it is impossible to reconcile Morgan Stanley’s EBITDA figures with Arthur Andersen & Co.’s determination o f cash provided by hospital operating activities. A reconciliation worksheet should have been provided but one was not For example, for the year 1995 the Morgan Stanley EBITDA figure is $14,135,000 while the Arthur Andersen & Co. audit report shows cash flow from operating activities to be $4,775,000. For the year 1994, the Morgan Stanley EBITDA figure is $11,480,000 while the Arthur Andersen & Co. audit report shows a deficit cash flow from operating activities of $2,384,000. Since EBITDA is supposed to be a proxy for the more accurate determination of operating cash flows required by FASB Statements Nos. 95, and 117, these rather large discrepancies for 1995 and 1994 would seem to be unacceptable but the error could be in the Attorney General’s interest Only for 1993 does Morgan Stanley’s 287 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. EBITDA figure ($13,194,000) appear to be reasonably close to Arthur Andersen’s determination of cash flow from operating activities ($14,513,000). The difference between the EBITDA column and die free cash flow column represents Morgan Stanley’s estimate of required capital expenditures. Again, it is not known how Morgan Stanley arrived at these estimates. Under FASB Statement Nos. 95 and 117, cash disbursements for required capital expenditures are not supposed to be subtracted from cash flows provided by operating activities. But some estimate of annual capital expenditures for the modernization of hospital plant and equipment is required in order to arrive at estimated “free” cash flow— the amount that is potentially distributable to creditors (as principal and interest) and stockholders (as dividends). Morgan Stanley used two discount rates: 7.4 percent and 9.4 percent According to its fairness opinion, these discount rates were based on the weighted average cost of equity capital for public companies in the hospital management industry (the reader is not told which ones) and the cost of debt capital for the Centinela Valley Health Services. To compute the enterprise’s terminal value (for years after 2000), a cash flow growth rate of 1% was used. The algebraic results for the two discount rates are: B E T - ± CF— + y (» O T .0 0 °X i.0 Q '-i a$92j251i400| S '(1 + 0 7 4 )' S (1 +.074)' b e v = ± CF^ + y (S L W o o o x i.o i) - i . S7U 18i200. tra+ 094)' s? (i+.094)* The first component reflects the present value of the “free cash flows” shown in Table 16 for the years 1996 through 2000 (the five-year forecast or projection), and the second 288 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. component reflects the terminal value of tire enterprise (a 1% annual growth in free cash flows commencing in the sixth year, or 2001, and continuing indefinitely). These figures are not identical to Morgan Stanley’s figures but they are within the range of the Morgan Stanley sensitivity analysis. The problem is that the Morgan Stanley opinion contains no valuation algebra so that the reader of the opinion must guess the valuation model that was used. Using the elementary formula for a constant growth perpetuity and the arithmetic mean of Morgan Stanley’s free cash flows for the ten-year period 1991 - 2000, it is possible to obtain reasonably comparable results with considerably less work. Table 16, supra, shows that the mean of the free cash flows for the ten-year period is 56,616,500. Assuming this amount will grow continuously at 1% per annum and that the appropriate discount rates are 7.4% and 9.4%, the results are: Assuming the discount rates of 7.4 percent and 9.4 percent are reasonable, the gross purchase price of approximately $96.8 million lies at the high end o f the valuation range. The reasonableness of Morgan Stanley’s discount rates is questionable because both of them appear to be low. For example, to evaluate Riverside Community Hospital, a discount rate of 16 percent was used, and to evaluate Pacific Hospital of Long Beach, the implicit discount rate was 20 percent Any error, however, would favor the public and not B E V = f (1.074)' = $103,382,812, and $6,616300(1.01) = $78,767300. 289 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the “for-profit” purchaser. If Morgan Stanley should have used a discount rate of, say, 12 percent, the constant growth annuity calculation would be: =$60,150.000. This is, of course, substantially less than the S96.8 million gross purchase price. The following table summarizes the results obtained by using DCF analysis: Table 17: Summary of Selected Valuation Results for Centinela Hospital M ethod 7.4% Discount Rate 9.4% Discount R ate Management’s forecast $92,251,400 $71,318,200 Constant growth perpetuity using $103,382,812 $78,767,900 10-year average as the initial value Source: Author’ s calculations. In its fairness opinion, Morgan Stanley gave a reference range for DCF valuation as being between $49.1 million and $72.7 million (with discount rates ranging from 7.4 percent to 9.4 percent). It is difficult to know how Morgan Stanley arrived at this range because the fairness opinion contains no appropriate audit trails or financial mathematics. Nevertheless, the actual purchase price of $96.8 million is beyond Morgan Stanley’s valuation range and it is also at the high end of the valuation range shown in Table 17. A discount rate of 12 percent, which would appear to be a more reasonable rate than 9.4 percent, would have produced a business enterprise value of approximately $60 million. 290 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Morgan Stanley also used secondary valuation methods as a “sanity check.” In applying the comparable companies and the comparable transactions methods, Morgan Stanley reviewed financial information on seven selected public companies, including Columbia/HCA, Tenet Healthcare, Health Management Associates, OrNda HealthCorp., and Champion Healthcare Corp., and data from eleven selected “public” acquisitions in the hospital management industry from April 1992 to October 1994. Market valuation, earnings per share, and EBITDA calculations were considered, but EBITDA appears to have been given the most weight Morgan Stanley’s EBITDA figure for the year ended June 30, 199S is approximately $13.2 million (this figure is slightly different from the EBITDA figure shown in Table 16 and the Morgan Stanley report contains no explanation), and hence the actual price-EBIDTA ratio is 7.33 (S96.8 million + $13.2 million). According to Irving Levin Associates (see Table 3, Chapter 2), the mean EBITDA multiplier for 19% non profit hospital transactions was 6.16 and the median was S.49. Therefore, the transactional ratio of 7J3 is certainly not suspect and Centinela’s purchase price of $%.8 million would appear to be better than prima fa cie reasonable. Morgan Stanley did not consider the price per bed. The purchase price of approximately $%.8 million is equivalent to a price of approximately $242,000 per bed, which is not unreasonable in the light of Irving Levin Associate’s data (see Table 3, Chapter 2). The Arthur Andersen & Co. audit report for the year ended June 30, 199S shows net patient revenue of approximately $140.9 million so that the ratio of hospital purchase price to net patient revenue ($98.6 * $140.9) is approximately 0.70. This ratio is 291 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. also within the profile of the non-profit hospital 19% acquisition data shown in Table 3, Chapter 2. Equation (9) may be used by applying the method of least squares to the cash flow data shown in Table 16 (last column). Morgan Stanley projected the hospital's post acquisition “free cash flows” for the years 19% through 2000, a period of five years. It also determined the hospital’s actual pre-acquisition free cash flows for the five period 1 9 9 1 through 199S. Thus, Morgan Stanley had ten free cash flow data points, as shown in the following table: Table 18: Morgan Stanley’s Free Cash Flows for Centinela Hospital Actual 1 9 9 1 56,840,000 Actual 1992 $7,606,000 Actual 1993 $5,713,000 Actual 1994 $3,785,000 Actual 1 9 9 S $7,899,000 Projected 19% $7,812,000 Projected 1997 $7,488,000 Projected 1998 $6,840,000 Projected 1999 $6,374,000 Projected 2000 $5,808,000 Mean $6,616,500 Source: M organ Stanley’ s fairness opinion. If the method of least squares is applied to all data points, both the historic and projected free cash flows, the linear time series equation is: fit) = $6,658,330-($7,606.06)1. 292 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Although the slope is negative, the application of equation (9) yields remarkably good results. For Morgan Stanley’s discount rates o f 7.4 percent and 9.4 percent, the valuation results are: BEV = J/(f)e~ 0 0 7 4 '<// = $88,588,500, and 0 BEV = = $69,972,500. o These values are extremely close to the results that Morgan Stanley obtained from only considering the present value of the hospital’s projected free cash flows ($92,251,400 and $71,318,200 respectively). Since the hospital’s actual sales price was approximately $96.8 million, equation (9) suggests a possible overpayment of approximately $8 million. In using the full ten-year period to value the hospital enterprise, the principal advantage is that all available information was used and no historical cash flow data was discarded. A principal objection to contemporary business valuation practices is that a business enterprise’s historical cash flow data is simply never used. Unfortunately, through the selective inclusion or exclusion of financial data, almost any business enterprise value can be calculated. Thus, there may be valuation mathematics but there is no valuation science. Equation (10) can be used with comparable results. Let k = $6.616,500 (die mean of the actual and projected cash flows shown in Table 18), g = 0.01 (to reflect Morgan Stanley’s 1 percent cash flow growth rate assumption), and i = 0.084 (to reflect the mean of Morgan Stanley’s discount rates of 7.4 percent and 9.4 percent). Substituting: 293 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. BEV = 6 1 6 ,5 0 0 = $ 8 9 , 4 1 2 , 1 6 2 . 0 .0 8 4 - 0 . 0 1 This figure is only slightly greater than the least squares result of approximately $88.58 million (for i = 7.4 percent). Thus, if one believes that the discount rate should be 7.4 percent and that the long-term post-acquisition cash flow growth rate should be 1 percent, equation (10) yields almost the same business enterprise value with considerably less work. The possible overpayment is, of course, somewhat smaller. B .5.3 P acific H o s p it a l of L ong B e a c h Over the years Pacific Hospital of Long Beach, a California nonprofit public benefit corporation, found it difficult to enter into managed care contracting relationships and thus remain competitive. In 1994, the 179-bed general acute care hospital retained the services of Cain Brothers, a health care consulting firm, to perform a market analysis and find a suitable strategic partner. Cain Brothers prepared a proposal package and solicited sealed bids from several potential buyers. The successful bidder, for approximately $5.5 million cash, was Healths mart Pacific, a California business corporation located in Huntington Beach, California.2 2 The purchase agreement was dated November 8, 1996, and the transaction closed on December 27, 19% (which was just a few days prior to the January 1,1997 effective date of California’s new hospital conversion law). Pacific Hospital was problematic because of the lack o f financial data, including cash flow forecasts or projections. The public file contained information from BDO Seidman, LLP, die hospital’s independent auditors, for the years 1995 and 19%. BDO 294 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Seidman’s report shows that net cash provided by operating activities was 52,999,195 for 1995 and a deficit of 5820,013 for 19%.2 3 Consequently, the two-year average is $1,089,591. Cain Brothers opined that hospitals are valued as a multiple of their cash flows and that in Pacific Hospital’s case a reasonable multiplier would be five (i.e., equivalent to a capitalization or discount rate of 20%). This, o f course, implies a value for Pacific Hospital of approximately 55.5 million (5 x $1,089,591 = 55,447,955). Although one might quarrel whether the multiplier should be five or six, I believe the 55.5 million estimate of hospital value is reasonable because it is based upon net operating cash flows for financial statement (FASB Statement Nos. 95 and 117) purposes. No projected or forecasted post-acquisition operating cash flows appear in the public file. The Attorney General did not quarrel with $5.5 million figure because his office viewed the transaction as too small to warrant the expenditure of substantial tune and resources. Cain Brothers also considered EBIDTA. Their valuation exercise shows EBIDTA calculations for several years: Table 19: Pacific Hospital's EBIDTA Calculations Year EBIDTA 1995 (estimate) 51,780,000 1994 5290,000 1 9 9 3 5980,000 3-Year Average J 1.016.667 Source: Cain Brothers. 295 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Since EBIDTA represents an estimate of net operating cash flows, if the capitalization or discount rate is 20%, the value of a perpetuity of SI million a year forever is $5 million. Unfortunately, it is impossible to determine the validity of these EBITDA figures because there is no linkage between Cain Brothers’ calculations and die BDO Seidman income statement A criticism is that a higher multiplier (die GAO’s typical figure of six) would have produced a greater value (approximately S6 million instead of $5 million). The comparable transactions approach suggests that there is evidence of a bargain purchase. According to Irving Levin Associates (see Table 3, Chapter 2), for 1995 the mean non-profit hospital purchase price was $277,219 per bed and the median non-profit hospital purchase price was $258,811 per bed.2 4 In its presentation to Pacific Hospital’s board of directors, Cain Brothers noted die existence of only 148 licensed beds. However, at 179 beds, the purchase price of $5.5 million is equivalent to only $30,726 per bed. One thing is clear, the price per bed is extraordinarily low. Even at a price of $100,000 per bed, the hospital should be worth at least $15 million. Pacific’s net patient revenue for 1995 was approximately $27.4 million, and for 1996 it was almost $28.1 million. Thus, the ratio of Pacific’s purchase price to its hospital patient revenue ($5.5 million * $28 million) is approximately 0.20. According to Irving Levin Associates (see Table 3, Chapter 2), the median price-to-revenue ratio for the acquisition years 1994 - 1997 ranged from 0.69 to 0.87.2 5 Pacific’s ratio of 0.20 is also extraordinarily low. At a ratio of only 0.50, the hospital should be worth at least $14 million. 296 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Other than the existence of a bargain purchase by HealthSmart, the only explanation for the obvious valuation discrepancy between the income approach (using cash flow or EBITDA) and the comparable transactions approach (using the price per bed and the ratio of purchase price-to-revenue) is that die hospital's directors believed subsequent declines in the hospital’s daily census would erode hospital value even further. According to information in the Attorney General's public file, between 1993 and 199S die hospital’s daily census declined by approximately 23 percent, and by the time o f the HealthSmart sale average hospital utilization of inpatient beds had fallen to less th an so percent Moreover, management had observed a decline in hospital revenues of 13 percent over the two years immediately preceding the sale and some directors believed that further revenue losses were inevitable. Given these difficulties, a rational buyer would be likely to substantially rely on the income approach and eschew secondary valuation methods. B.5.4 U nited W estern M edical Centers United Western Medical Centers, a California nonprofit public benefit corporation, owned and operated three hospitals in Orange County, California: Anaheim (171 operational beds but 191 licensed), Bartlett (188 operational beds but 241 licensed), and Santa Ana (246 operational beds but 301 licensed), for a total o f4 3 4 operational beds but 733 licensed. As a result of cash flow problems, in 1996 United’s board of directors decided to solicit purchase bids from three “for-profit” hospital chains: OrNda HealthCorp., Tenet Healthcare Corp., and Columbia/HCA. The board decided that the bidders should be evaluated on the basis of die following factors: the amount of cash that would become available to fund United’s charitable foundation, the perceived quality of 297 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. each bidder based upon physician responses, die ability to close the transaction, and the reputation of other hospitals owned by each of the bidders. Although Columbia/HCA was the board's perceived favorite, OrNda’s bid prevailed because it finally agreed to pay approximately S177 million for die three hospitals compared to Tenet’s final bid of $1 IS million and Columbia’s final bid of $124 million. Because the closing date was on or before December 31, 1996, the hospital sale transaction was governed by California’s old law. For each bid, Table 20 shows the base purchase price and the amount of cash to be set-aside for charitable purposes; Table 20: Purchase Bids for United Western Medical Centers Columbia OrN da Tenet Letter of intent dated June 21,1996 June 10,1996 May 31,19% Base purchase price $124,000,000 $177,483,000 $115,000,000 Less: payment of indebtedness $91,759,000 137,659,000 $89,700,000 Phis: existing funds held in trust $7,572,000 $7,572,000 $7,572,000 Cash available for charitable use $39,813,000 $47,396,000 $32,872,000 Source: Documents in Attorney General's public transactional file and author’s calculations. OrNda’s net purchase price for the hospital assets was actually $132 million, as shown by the following abbreviated accounting; 298 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Gross purchase price Liabilities assumed by purchaser Net purchase price paid to seller $177,483,000 ( 4 5 .4 8 3 .0 0 0 ) 132.000.000 Cash paid to non-profit seller Cash used to retire existing debt Charitable cash on hand Net cash for charitable use $132,000,000 ( 92,1 7 6 ,0 0 0 ) 7 .57 2 .0 0 0 $ 4 7 .3 9 6 .0 0 0 As part of the purchase transaction, OrNda agreed to assume certain liabilities and the non profit seller agreed to retain certain liabilities. The liabilities assumed and retained equal the payment of indebtedness shown in Table 20. The valuation of the United’s three-hospital package is problematic due to a lack of financial data. According to Ernst & Young’s consolidated report, for the year ended March 31, 1994, cash flow provided by operations was $12,992,000 million, and for the year ended March 31, 1995 it was $6,235,000. The two-year mean cash flow provided by operations is approximately $9.6 million. Although it would be helpful to have more data points, there is no additional financial information in die public file. Using the constant growth perpetuity model, a sensitivity matrix (Table 21) can be developed to support a purchase price between $86.8 million and $191.0 million. Table 21: Valuation Sensitivity Matrix i = 10% I = 12% i = 1 4 % g = 3% $136.4 million $106.1 million $86.8 million g = 4% $1592 million $119.4 million $95.5 million g = 5% $191.0 million $136.4 million $106.1 million Source: Author’s calculations. 299 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The actual purchase price of approximately $177 million is consistent with a low discount rate and a high cash flow growth rate, and thus it is within the range of values supported by the sensitivity analysis. Secondary methods (the comparable transactions method) suggest that the $177 million purchase price was reasonable. First, in the aggregate, OrNda purchased 733 licensed beds (but a total of 434 operational beds). The purchase price of approximately $177 million is the equivalent of slightly more than $241,000 per licensed bed. This is a reasonable figure because, for 1996, Irving Levin Associates, reported the mean hospital purchase price per bed to be $253,308 and the median hospital purchase price per bed to be only $183,146 (Table 3, Chapter 2). Second, according to Ernst & Young’s report, consolidated net patient service revenue was approximately $172.3 million for the year ended March 31, 1995 and $169.5 million for the year ended March 31, 19%, for a two- year mean of approximately $171 million. The purchase price-to-patient revenue ratio of 1.03 ($177 million * $171 million) is only slightly higher than the ratios reported by Irving Levin Associates for 1995 and 19% (see Table 3, Chapter 2). Although no EBITDA calculation appears to have been made, one can be derived from the Ernst & Young audit report: Table 22: Pacific Hospital's EBITDA Calculations March31, 1995 March 31.1994 Total revenues in excess of expenses Add: interest expense Add: depreciation expense Estimated EBITDA $707,000 $6,816,000 $5,017,000 $5,615,000 $9,030,000 $8,102,000 $14,754,000 $20,533,000 Source: Ernst & Young LLP and author’s calculations. 300 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The two-year EBITDA average is approximately S17.6 million, and thus the $177 million gross purchase price is consistent with a multiplier of approximately 10. The net purchase price of $132 million, however, is consistent with a multiplier of approximately 7.5. This illustrates two fundamental problems with EBITDA: first, die maimer of determining hospital purchase prices may depend upon how liabilities are treated and repented to secondary valuation sources such Irving Levin Associates; second, there is no uniform EBITDA formula so that different analysts can arrive at different EBITDA calculations. B.5.5 Q u e e n of A n g e l e s— H o l l y w o o d P r e s b y t e r ia n M e d ic a l C e n t e r On December 18, 1997, the board of directors of Queen of Angels—Hollywood Presbyterian Medical Center (Queen of Angels), a tax-exempt California nonprofit public benefit corporation, agreed to sell Queen of Angel’s hospital business (i.e., its real property and all other hospital operating assets) to a subsidiary of Tenet HealthSystem Hospitals, Inc., a Delaware “for profit’ ’ corporation. The consideration for the sale would be $86.4 million cash plus certain post-closing adjustments, including Queen of Angel’s entitlement to certain grants from the State of California estimated to be $45 J million, or a total purchase price of approximately $131.7 million.2 6 Since 1994, Queen of Angels board of directors had been discussing what to do about the hospital’s declining patient census and income erosion due to mandated reductions in Medicare and Medi-Cal payments. O f the hospital's 416 licensed beds, only 364 were staffed. The board decided that if die hospital facility were to continue to exist a strong financial partner would have to be found.2 7 301 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. To generate interest, beginning in 1994 the board made telephone contact with a limited number of “for-profit’ ’ and “non-profit’ ’ organizations, including Columbia/HCA Healthcare, Tenet HealthSystem, Quorum, Catholic Healthcare West, and die Sisters of Saint Joseph of Carondelet, Sutter/CHS, and OrNda. The board decided not to pursue die marketing strategy of an auction or a widely distributed “request for proposal” because it believed that the publicity would tend to hamper hospital operations. Over the next three years, the board evaluated the merits and the financial offers of several suitors, including offers from OrNda and Columbia/HCA. On August IS, 1997, after negotiations had begun but failed with OrNda and Columbia/HCA, the Queen of Angel’s board issued a letter of intent to Tenet HealthSystem Hospitals, Inc. On December 18, 1997, Queen of Angels issued the obligatory statutory notice2 * to the California Attorney General, and on May IS, 1998, the transaction was approved.2 9 The hospital’s board of directors believed that the value of the medical center (including the value of the grants due to the medical center from the State of California) was between S85 million and $137 million. In its March 20,1998 report, Arthur Andersen LLP, whom the Attorney General hired as an independent expert to review the financial aspects of the proposed transaction, presented the following cash flow information: 302 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 23: Queen of Angel's Cash Flow Projections Year Management’s Unadjusted Free Cash Flow Projection Management’ s Adjusted Free Cash Flow Projections Management’ s Aggressive Free Cash Flow Projections M anagem ent’s Estimate of State Grants Projected 1 9 9 8 52,802,936 $2,802^)36 52,802,936 $2,444,400 Projected 1 9 9 9 55,093,297 $14399,666 $14399.666 $11,077,140 Projected 2000 $4,296,517 $13330,473 $13360,603 $9,884,700 Projected 2 0 0 1 $4312390 $12,781,126 $13383,897 $8,158300 Projected 2 0 0 2 $5,536,238 513,996326 $14,781,867 $7,782340 Column M e a n S4.388.396 SI1.462.085 SI1.765.794 S7.869.456 Source: Arthur Andersen L LP. Arthur Andersen used a weighted average cost of capital o f 18% and the mid-year discounting convention3 0 to arrive at the following values for the medical center (exclusive of the disproportionate share payments or state grants): B E V ^ , = V u s f + V n s t ^ 8)- = 528487,700, m m m m g ff(l + .18)' tS (1 + .18) B E V ^ . = (S‘ , f l f 6) - $73455,000, and /.i u + .io; ii + .isj BEV W = V T is f CF|997^ - h V u s Y ^ 1 - - - 78186^ = $76,234,400. t r ( l + .18)' £ (1 + .18) Using the same discount rate and mid-year discounting convention, the value of the disproportionate share payments or state grants was determined to be: 303 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. GrantsM = V T l 8 ^ - ^ ^ + V u 5 £ 5 L Z E |E = $4642VOO. 7Z (1 + . 18) tS (1 + -18)' In all cases (the medical center and the state grants), a “no growth” assumption was used; i.e., terminal values were computed assuming that after die fifth year cash flows would remain constant Using the above figures, the range o f value for the medical center (including the value of the state grants) is approximately $752 million - $122.4 million.3 1 If the mean of the column means for management’s three scenarios ($9,205,425) is used as the initial value for a growing perpetuity,3 2 it is easy to generate the following sensitivity matrix for the value of the medical center by itself: Table 24: Valuation Sensitivity Matrix /= 1 4 % i = 1 6 % i = 1 8 % f = l% $ 7 1 million $61 million $54 million g - 2% $77 million $66 million $58 million g = 3% $84 million $71 million $ 6 1 million Source: Author's calculations. In other words, for discount rates between 14% and 18%, and for cash flow growth rates between 1% and 3%, the medical center’s value is between (approximately) $54 million and $84 million. This method of analysis is perhaps less sophisticated but the results are comparable to Arthur Andersen’s results for die medical center by itself. It is interesting to compare management’s cash flow projections shown in Arthur Andersen’s valuation report with the cash flows provided by operating activities shown in Coopers & Lybrand’s audit report for die years 1991 through 1995: 304 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 25: Queen of A igds’ Actual Operating Cash Flows Year Net Cash Provided by Operating Activities Net Cash Provided by State Grants Actual 1 9 9 1 $6,788,805 $0 Actual 1 9 9 2 $21340,744 $0 Actual 1 9 9 3 $19363310 $0 Actual 1 9 9 4 $2,147,000 $52,412,000 Actual 1 9 9 5 $12,793,000 $59,120,000 Column M e a n S12.466.612 $55.766.000 Source: Coopers & Lybrand. The Coopers & Lybrand figures shown above reflect the historical net cash flows from hospital operating activities. Assuming a discount rate of 18% and no cash flow growth, the value of the medical center’s cash flow perpetuity is approximately S69.2 million ($12,466,612 + 0.18). Assuming a discount rate of 18% and a cash flow growth rate of 1%, the value of the medical center’s cash flow perpetuity increases to approximately $733 million ($12,466,612 * 0.17). The latter value is consistent with some of the values derived by Arthur Andersen from management’s adjusted projections (Table 24, supra). Thus, it would appear that management’s pro form a cash flow projections or forecasts contained very little additional information about the medical center’s prospective value. (The value of the state grants is necessarily problematic because of legislative and administrative uncertainty.) The Arthur Andersen valuation report that was prepared for the Attorney General estimates that Tenet would be required to pay approximately $131.7 million for the medical center the $86.4 agreed upon cadi price plus post-closing adjustments (including 305 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the value of certain state grants) of $453 million. The agreed upon cash price ($86.4 million) reflects the value of the medical center’s estimated future operating cash flows, and in the light of the DCF analysis this price is certainly reasonable. The major uncertainty, and thus purchase price risk, would appear to be the amount paid for die value of the disproportionate share payments or state grants. Although the Arthur Andersen valuation report placed great emphasis on the DCF approach to value the medical center, the report also considered both the comparable transactions approach and the comparable companies approach. Table 26 shows the results of Arthur Andersen’s EBITDA calculations for the medical center Table 26: Queen of Angels’ EBITDA Year Net Income EBITDA June 30,1993 $21,045,000 $20,375,000 June 30, 1 9 9 4 $54,176,000 $16,538,000 June 30,1 9 9 S $62,184,000 $15,535,000 June 30,19% $31,403,000 $9,394,000 June 30,1997 $53,499,000 $15322,000 Column Mean $44,461,400 $15,432,800 Source: Arthur Andersen L L P . Since Arthur Andersen did not reconcile its EBITDA calculations to hospital net income, the amount and character of the EBITDA adjustments are unknown. Coincidentally, the 5- year mean of approximately $15.4 million is somewhat close to Coopers & Lybrand’s historic net operating cash flow mean of approximately $12.4 million (Table 25). Applying the GAO’s typical EBITDA multiplier of six to the 5-year EBITDA mean, the value o f the medical center is estimated to be approximately $92.5 million. This value is 306 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. slightly higher than management’s aggressive DCF estimate of approximately $76.2 million and slightly beyond the range of values shown in Table 24. Applying the GAO’s typical multiplier to the Cooper & Lybrand’s historic operating cash flow mean, the value of die medical center is estimated to be approximately $74.4 million, which is within Arthur Andersen’s valuation range. Although Arthur Andersen did not consider die price per bed, that figure for the medical center is $207,692 ($86.4 million 416 beds), which is slightly above the 1997 median shown in Table 3, Chapter 2. Using the total purchase price of approximately $131.7 million, the price per bed is $316,586, an amount that is greater than the average price per bed statistics shown in Table 3, Chapter 2, for the years 1994 through 1997. Because of uncertainty surrounding the State’s disproportionate share payments or grants, there is a risk that Tenet may have overpaid for Queen of Angels. The major uncertainty is the amount and timing, and hence the value, of the disproportionate share payments or state grants that the hospital will receive in future years. Arthur Andersen valued the grants at approximately $46.2 million, but subsequently reduced the value to approximately $33.9 million. Equation (9) may be used to produce somewhat different results. As previously mentioned, hospital management made three different projections entitled unadjusted, adjusted, and aggressive. Management’s “aggressive” dee cash flow projections are shown below: 307 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 27: Management’s Aggressive Free Cash Flows Projected 1 9 9 8 Projected 1999 Projected 2000 Projected 2 0 0 1 Projected 2002 $2,802^36 514399,666 $13360,603 $13,283,897 $14,781,867 Mean $11.765.794 Source: Arthur Andersen LLP. The resultant least square time series is: fit) = $4,913,170 + ($2.284.210)t. Using Arthur Andersen’s discount rate of 18 percent and equation (9), the business enterprise valuation result is: This figure is greater than Arthur Andersen’s figure of $76,234,400, which suggests that Arthur Andersen may have undervalued the hospital enterprise because of its post acquisition “no growth’ ’ assumption. Of course, the lack of historical cash flow H«ta may be an important mitigating factor; i.e., the data, if it did exist, might reduce the slope or the intercept of the linear time series equation and thus the valuation result To use equation (10), let k = $11,765,794 (the mean of the projected cash flows shown in Table 27), g = 0 (to reflect Arthur Andersen’s 0 percent cash flow growth rate assumption), and i = 0.18 (to reflect Arthur Andersen’s discount rate of 18). The result is: o 308 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. BEV = $11’765’? - - = $65365,522. 0 .1 8 -0 This figure is less than the Arthur Andersen figure of $76,234,400. If, however, the “outlier” for 1998 is discarded so that k = $14,006,508 (the mean of the projected cash flows for the years 1999,2000,2001, and 2002), the result is: BEV = S14* 006* 5 0 8 = 577 g 0 ,9 3 3, 0 .1 8 -0 which is very close to Arthur Andersen’s value of $76,234,000. Once again, by judiciously including or excluding data, one can use an elementary annuity formula to derive almost any business enterprise value. Tenet HealthSystem paid approximately $86.4 million cash for the hospital and another $45.3 million for the value of certain state grants. Equation (9) suggests a value of approximately $97.8milIion for the hospital, while equation (10) suggests a hospital value of between $653 million and $77.8 million. On balance, it would appear that Tenet’s cash cost for the hospital was reasonable. B.5.6 R iv e r sid e C o m m u n i t y H o s p it a l Founded in 1901, Riverside Community Hospital, a California nonprofit public benefit corporation, was the largest fiill-service, acute care facility in western Riverside County (approximately 369 beds). Because of declining operating margins, high debt load, and the need to obtain access to national contracts covering enrollees in health plans, the hospital’s board of directors decided that the hospital should be purchased by any one of 309 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. S t Joseph Health System, Catholic Healthcare West, Tenet or Columbia/HCA. Ultimately, the board decided that Columbia/HCA would be the best candidate to purchase the hospital. In April 1997, the California Attorney General’s office approved the acquisition of Riverside Community Hospital by an affiliate of Columbia/HCA Healthcare. This was the first conversion transaction under California’s new law giving the Attorney General responsibilities for transactional oversight3 3 The cash purchase price was $70.5 million. To effect the purchase, Columbia would establish a newly formed limited liability company (LLC) and contribute $70.5 million cash to that company. Next, the hospital would contribute all of its assets to the newly formed Delaware LLC in exchange for some of the cash and a 25 percent equity interest in the LLC. The hospital would use the cash to retire its outstanding tax-exempt bonds and other indebtedness. The balance (approximately $21 million) would be left for charitable purposes. An abbreviated accounting is: Valuation $70,500,000 Purchase price adjustments3 4 ( 7.637.1501 Adjusted purchase price 62.862.850 Cash received by seller hospital (75%) $47,147,138 Value of 25% interest in LLC 15.715.712 Adjusted purchase price (value) 62.862.850 Hospital cash on hand $18,285,000 Other realizable hospital assets 8,805,018 Cash received by seller 47.147.138 Total liquid assets 74,237,156 Cash used to retire indebtedness (53.398.976) Net cash for charitable use 20.838.180 310 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Although the hospital’s purchase price was pegged at $70.5 million, the hospital did not receive $70.5 million in cash. It received 75% of its value in cash (approximately $47.1 million) and 25% of its value (approximately $15.7 million) in the form of an equity interest in a joint venture operating company (i.e., the newly formed LLC). Because of the Attorney General’s “monetization” concern (i.e., his concern that the 25% equity interest might be unrealizable), as a condition for allowing the transaction to proceed, Riverside Community Hospital was given a “put” (i.e., the right to require Columbia/HCA to purchase its 25% LLC interest for cash) exercisable at any time. For valuation and charitable set-aside purposes, the Los Angeles office of Ernst & Young LLP prepared and issued a valuation report dated January 31, 1997 using the comparable transactions approach, the comparable companies method, and the discounted cash flow method. Table 28 shows the valuation results: Table 28: Summary of Valuation Methods for Riverside Community Hospital M ethod Estimated Value Com parable transactions S 7 1 million Com parable companies S63 million Discounted cash flow $60 million Source: Emst & Y oung LLP. Ultimately Riverside’s value as of August 31, 1996 was determined to be $70.5 million; i.e., the highest value shown in Table 28. Some valuation analysts would have determined the best estimate of Riverside’s value to be the arithmetic mean of the three methods ($64.6 million). 311 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In applying the comparable transactions method, Ernst & Young identified 107 hospital transactions or deals from May 1993 through August 1996. Nothing is known about these transactions, as only summary information appears in the Ernst & Young valuation report For these 107 hospital deals, the average (mean) EBITDA multiplier was determined to be 7.4 and the average (mean) price per hospital bed was found to be $215,300. Using an EBITDA figure of $9,594,000 for Riverside Hospital and a multiplier of 7.4, Ernst & Young obtained a value of $70,995,600, or approximately $71 million as shown in Table 28, above. It was not possible for me to derive Ernst & Young’s EBITDA figure of 59,594,000 from the Ernst & Young audited financial statements for the years 1993, 1994, and 1995, and the Ernst & Young valuation report contains no reconciliation or analysis. Ernst & Young also used public transaction hospital bed information (i.e., price paid per bed) to estimate Riverside’s value. Using Riverside’s 369 beds, Ernst & Young obtained a value of $79,445,700 (369 x $215,300), or approximately $79 million. It is not clear why Ernst & Young chose to rely on the EBITDA multiplier instead of the hospital bed multiplier. The results obtained by using both multipliers could have been averaged to suggest a hospital value of $75 million. In applying the comparable companies approach, Ernst & Young used valuation multiples derived from the operating data of several publicly-held companies, including the following New York Stock Exchange listed companies: Health Management, OrNda Healthcorp., Paracelsus Healthcare, Tenet Healthcare, and Universal Health. Unfortunately, it is not possible to replicate Ernst & Young’s results because of the cursory nature of the Ernst & Young valuation report; i.e., no financial details were provided. 312 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. As discussed in Chapter 2, Ernst & Young used DCF analysis to arrive at a business enterprise value {BEV) of $59.8 million (approximately $60 million). Interestingly, no discount or growth rate sensitivity analysis was provided. Since slight changes in the discount rate and growth rate assumptions can produce large fluctuations in value, a sensitivity analysis should have been made. Using Ernst & Young’s valuation methodology, the following Table 29 shows the effect of varying the discount rate and management’s forecast of the cash flow growth rate: Table 29: Discount and Growth Rate Sensitivity Analysis i=15% i = 16% /= 17% g = 3% $615 million S S 6.6 million $52.4 million g = 4% $65.4 million S59.8 million $55.1 million g = 5% $70.2 million $63.7 million $58.3 million Source: Author’ s calculations. The sensitivity analysis shows the BEV range to be approximately $18 million (the difference between the maximum table value of $70.2 million and the minimum table value of $52.4 million). This valuation range suggests that Columbia/HCA did not obtain a bargain purchase. In fact, if the discounted cash flow methodology is the “gold standard” of business enterprise valuation, die results suggest that Columbia/HCA should have paid approximately $60 million instead of $70.5 million for the operating assets of Riverside Community Hospital. The Attorney General hired Arthur Andersen LLP to review the January 31, 1997 Ernst & Young valuation report Arthur Andersen raised several objections to die Ernst & 313 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Young report, but its principal objection was Ernst & Young’s failure to investigate or verify management’s cash flow projections. Indeed, the Ernst & Young valuation report contains no historical cash flow information, and nothing to suggest how hospital management obtained the cash flow projections it did. Moreover, there were no cash flow statements prepared in accordance with FASB Statement Nos. 95 and 117. Consequently, there was nothing to link management’s cash flow projections to the hospital’s financial statements. The Arthur Andersen critique does not mention the EBITDA calculation. The Ernst & Young audit reports for the years 1992, 1994, and 1995 reflect the following information: Table 30: Selected Financial Data for Riverside Community Hospital 19 9 5 1994 1993 Total operating revenue 398,579,887 $94,935,008 $94,004336 Total operating expenses 595,788,896 $92,612330 $89,818,468 Revenues over Expenses $2,790,991 $2322,678 $4,186,068 Sourer. Erast & Young LLP. To arrive at EBITDA, it is necessary to add back interest, taxes (if any), and depreciation expense. Nonrecurring or unusual items of income and expense should be eliminated, since the goal is to approximate the entity’s flee cash flow from ordinary and recurring business operations. Taking into account the required “add backs’ * and eliminating nonrecurring investment and other income, the EBIDTA calculation is shown in Table 31, below: 314 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 31: Determination of EBITDA for Riverside Community Hospital 1995 19 9 4 1 993 Total operating revenue $98,579,887 $94,935,008 $94,004436 Total operating expenses $95,788,896 $92,612430 $89,818,468 Revenues over expenses 52,790.991 $2422,678 $4,186,068 Add: interest expense $4,148,883 $4435,774 $4,056426 Add: depreciation expense $6,740,374 $6431,016 $6444412 Less: investment income $5,107,231 Less: other revenue $2,431461 $3,175,798 Estimated EBITDA $8473,017 $11,158,107 $11,411,408 Source: Ernst & Young LLP and author’s calculations. For the years shown above, the 3-year average EBITDA is $10,3 8 0,8 4 4. As previously mentioned, the derivation of Ernst & Young’s EBITDA figure ($9,594,000) is unknown. However, using Ernst &Young*s EBITDA multiplier of 7.4, Riverside’s suggested valuation is $76,818,246 (7.4 x $10,380,844), or approximately $76.8 million, instead of approximately $71 million. In this case, the difference is not substantial but it does illustrate the power of EBITDA adjustments to affect enterprise valuation. The GAO’s findings that investment bankers commonly used a multiplier of six would yield an implicit value of $62,285,064 (6 x $10,380,844), or approximately $62.2 million. In fact, die $62.2 million figure is very close to die EXT analysis figure of approximately $60 million. One could conclude that $60 million is a better estimate of value than $70.5 million, in which case Columbia overpaid for die hospital. Using DCF methodology, it is possible to make a more thorough valuation review. The transaction file indicates that Riverside’s management projected that the hospital’s post-acquisition cash flows would be as follows: 315 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 32: Management's Projected Post-Acquisition Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 $4,067,000 $5,167,000 $6,429,000 $8,901,000 $8,517,000 Mean S6.6I6.200 Source: Attorney General’s public transaction file. Applying the method of least squares to the data shown in Table 32, it is easy to derive the f(t) = $2.826.000 + ($1.263,400)t. Using equation (9) coupled with management’s discount rate of 16 percent (i = 0.16), the business enterprise value (BEV) of Riverside Community Hospital is easily determined to This figure (approximately $67 million) is slightly greater than Ernst & Young’s discounted cash flow business enterprise value of approximately $60 million, but it is very close to the Ernst & Young’s reported value (and purchase price) of approximately $70.5 million. Equation (10) can also be used with reasonably good results. Let k = $6,616,200 (the mean of management’s projected post-acquisition flows shown in Table 32), g = 0.04 linear time series trend equation,3 5 be: BEV= j f ( t ) e '0 A 6 'd t = $67,014,100. o 316 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (management’s assumed cash flow growth rate of 4 percent), and i = 0.16 (to reflect Ernst & Young’s discount rate of 16 percent), then BEV = 56,616,200 = $55435,000, 0.16-0.04 which, given the lack of precision one would expect to be associated with business enterprise valuation, is a satisfactory and a somewhat more conservative result In the light of equation (10), one could claim that Columbia/HCA overpaid for the hospital by approximately $15.4 million (i.e., $70.5 million - $55.1 million). B.5.7 Sharp H ealthcare In August 1996, the San Diego Hospital Association, a California nonprofit public benefit corporation, notified the Attorney General that it would sell or contribute Sharp Memorial Hospital, Sharp Temecula Valley Hospital, and other nonprofit health care facilities (collectively known as “Sharp Healthcare” or “Sharp”) to a Delaware limited liability company to be owned 50% by the Association and 50% by Columbia/HCA Healthcare Corporation. The proposed closing date was on or before December 31, 1996 so that the old law would control the transaction. One year earlier, die Association’s board of directors had decided that Sharp would have to take on a “for-profit” mindset in order to compete in the current market and so it retained the services of Shattuck Hammond Partners to evaluate Sharp and solicit bids from interested “for-profit” hospital chains, including Columbia/HCA, Tenet Healthcare, and OrNda HealthCorp. Although Tenet was prepared to pay more for the Sharp assets than Columbia, the board chose Columbia. It is not clear why the board made the decision it did. 317 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Based upon the methodologies shown in Table 33 below, Shattuck Hammond determined that the business enterprise value o f die San Diego Hospital Association was between $275 million and $390 million: Table 33: Sharp Valuation Estimates M ethod Minimum Value Maximum Value Comparable companies $275 million $360 million Comparable transactions $310 million $390 million D CF $310 million $370 million Source: Shattuck Hammond Partners. In its fairness opinion, however, Shattuck Hammond stated that the valuation range was between $360 million and $390 million. It is not clear why Shattuck Hammond chose to ignore the minimum values shown in Table 33. The consideration for the Association’s transfer of Sharp operating assets to the newly formed Delaware limited liability company was $193 million cash, a 50% interest in a limited liability company (worth an estimated $5 million), and a “put” (i.e., an option to force Columbia/HCA to purchase the Association’s 50% interest in the limited liability company) worth between $20 million and $30 million.3 6 The Attorney General’s concern was that at the time of closing the entire package offered by Columbia/HCA was worth between $218 million and $228 million, which was less than Shattuck Hammond’s range of value (between $360 million and $390 million) for the Sharp assets. Because the consummation of the Columbia/HCA proposal could cost the Association and thus the public interest in excess of $100 million, the Attorney General notified the Association that 318 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. he would seek to hold die directors who voted to approve the transaction personally liable for any breach o f charitable trust In February 1997, Sharp announced that it was terminating its joint venture agreement with Columbia/HCA.3 7 Although die Sharp transaction was not consummated, it is still useful to consider how Shattuck Hammond obtained its estimate of hospital value. Shattuck Hammond actually prepared “free cash flow” projections for a five-year period. The results, shown together with Deloitte & Touche’s historical information, are presented in the following table: Table 34: Sharp’s Cash Flows Year Deloitte & Touche’s Cash Flow s from O perations Shattuck Hammond’s Gross Cash Flows, Less Income Taxes Shattuck Hammond's Free Cash Flows Actual 1 9 9 3 559,859,000 Actual 1994 $41,725,000 Actual 1 9 9 5 $56,479,000 Actual 19% Not available Projected 1997 $42,651,800 $9,650,000 Projected 1998 $43,406,200 $13,049,000 Projected 1999 $46,306,400 $15,171,000 Projected 2000 $53,563,000 $20,405,000 Projected 2001 $60,922,400 $27470,000 Column Mean SS2.687.667 S49.369.960 SI7.169.000 Source: Deloitte & Touche LLP and Shattuck Hammond Partners. It is not clear how Shattuck Hammond derived its gross operating cash flow projections for the years 1997 through 2001, but they appear to be reasonably close to Deloitte & Touche’s historical cash flows from hospital operations for the years 1993 through 1995. Unfortunately, there is no linkage or audit trail between die Shattuck 319 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hammond analysis and the Deloitte & Touche audit report. For example, for the year ended September 30, 1995, Deloitte & Touche reported net patient revenues to be approximately S685 million but the Shattuck Hammond valuation analysis shows net patient revenues for 1995 to have been approximately $421 million. Even after subtracting the net patient revenues of Sharp Coronado Hospital and Grossmont Hospital Corporation, both of which were excluded from die proposed Columbia/HCA acquisition, there is sdll an unexplained net patient revenue difference of approximately $92 million. Another problem is that Shattuck Hammond deducted estimated capital expenditures to arrive at the “free cash flows’ ' shown in Table 34. There is nothing that tells the reader how Shattuck Hammond arrived at its estimate of these expenditures. Because of capital expenditure uncertainty, it is easy to manipulate the determination of “free cash flow” to support a broad range of business enterprise value. The Shattuck Hammond report contains no valuation mathematics but it is possible to replicate Shattuck Hammond’s range of hospital value (between $310 million and $390 million). In applying DCF analysis to the free cash flows shown in Table 34, Shattuck Hammond used discount rates ranging from 12.6% to 15.2% to reflect the weighted average cost of capital in the hospital industry. Shattuck Hammond also assumed that, commencing in year 2002, cash flow would grow at the rate of 5 percent per annum. Unfortunately, using discount rates of 1 2 percent and 16 percent, the business enterprise valuation (BEV) figures are remarkably low: BEV - 70,000X1.05)-:’ ^ ■ S T (1+.12) £ (1+.12) 320 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. BEV = t C F ' **~ + y (S27^70!000X1:0S)< 5 = £T(1 + .16)' £ (1+.16)' The only way to approach the Shattuck Hammond DCF range of value is to increase the free cash flow terminal value growth rate to an amount greater than 5%. With a sensitivity analysis it is possible to replicate Shattuck Hammond's valuation results. Using the growing perpetuity model and die 5-year mean of Shattuck Hammond's projected free cash flows ($17,169,000) as the base, the business enterprise valuation results are: Table 35: Sensitivity Analysis Using Shattuck Hammond Data /=12% /= 14% i=16% g = 5% $245 million $191 million $156 million g = 6% $286 m illion $215 million $172 million g = 7% $343 m illion $245 million $191 million g = 8% $429 m illion $286 million $215 million Source: Author’s calculations. The above table shows that the Shattuck Hammond reported DCF range of value ($310 million - $370 million) is consistent with a lower discount rate (between, say, 12% and 14%) and a higher terminal value growth rate (between, say, 7% and 8%). For example, a business enterprise value of $350 million requires a capitalization factor of: ($17,169,000 *$350,000,000) = 0.0491. This is factor is consistent with a discount rate of 12 percent and a terminal value growth rate of 7.09% (i.e., i - g = 0.0491). The problem is that the high growth rate is suspect 321 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. On die other hand, the factor is also consistent with a discount rate o f 7.91 percent and a growth rate of 3 percent per annum. In valuing Centinela Hospital, Morgan Stanley used discount rates of 7.4 percent and 9.4 percent Deloitte & Touche's historical operating cash flow figures can be used to approach the Shattuck Hammond DCF range of value at a greatly reduced terminal value growth rate. The three-year mean (Table 34, supra) is approximately $52,687 million. If the three-year mean is used as the initial or base cash flow for a constant growth perpetuity, the following valuation matrix can be obtained: Table 36: Sensitivity Analysis Using Deloitte & Touche Data i = 1 2 % i = 14% i = 16% g = 1 % $479 million $405 million $351 million g — 2% $527 million $439 million $376 million g = 3% $585 million $479 million $405 million Source: Author’s calculations. The range of value shown in the third column (a discount rate of 16%, which was used by Ernst & Young to discount Riverside Community Hospital’s cash flows) of the valuation matrix is only slightly greater than the DCF range of value developed by Shattuck Hammond ($310 million - $370 million). It is interesting to note that die constant growth perpetuity method, which is easy to use, can provide valuation results consistent with those obtained by using methods that are more sophisticated. The major problem, however, is that the Deloitte & Touche figures reflect the cash flow results o f the two excluded 322 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospitals (Sharp Coronado Hospital and Grossmont Hospital Corporation), so that there is some valuation overstatement From Shattuck Hammond’s valuation analysis it is possible to determine EBITDA. For the two years 1994 and 199S, the mean EBITDA is approximately S42 million. Using a multiplier of six, the GAO’s typical multiplier, the value of the hospital is S2S2 million. Using a multiplier of seven, die value is S294 million. Both of these values appear to be low in relation to Shattuck Hammond’s ultimate findings of value. Although the Attorney General may have been correct to conclude that Columbia/HCA’s offer of between $218 million and $228 million was too low, it would appear that Shattuck Hammond’s estimate of value (between $360 million and $390 million) may have been too high. Using a discount rate of 1 2 percent and a terminal value growth rate of 5 percent, Shattuck Hammond’s DCF analysis would suggest a value of approximately $293 million. The sensitivity analysis presented in Table 36 (supra) is especially instructive, because it shows that Shattuck Hammond’s higher business enterprise values require extremely high terminal value cash flow growth rates. I suspect that Columbia/HCA’s management offered what it did (approximately $228 million) because it was unwilling to incur die high growth rate risk. If the transaction had been consummated the financial information in die public file would have been more complete. Equation (10) coupled with the method of least squares can be used to examine Shattuck Hammond’s valuation of Sharp. Shattuck Hammond’s projected free cash flows are shown below: 323 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 37: Shattuck Hammond's Projected Free Cash Flows Projected 1997 S9.6S0.000 Projected 1998 S13.049.000 Projected 1999 S1S.171.000 Projected 2000 S20.40S.000 Projected 2001 S27.S70.000 Mean S17.I69.000 Source: Shattuck Hammond Partners. The cash flows are strictly increasing and the resultant least squares time series function is: f(t) = $42,102,000 + ($4.319.600)1. Using discount rates of 12 percent and 16 percent, the equation (8) business valuation figures are: 40 BEV = J /( /) e “° 1 2 1 d t = $335,057,000, and 0 In its valuation report, Shattuck Hammond opined that the present value of Sharp’s projected cash flows was between $310 million and $370 million. Using a mechanical time series approach, a better estimate would appear to be between $195 million and $335 million, depending upon the discount rate. It is unfortunate that Shattuck Hammond did 324 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. not determine free cash flows for the five-year period immediately preceding the hospital’s possible sale so that historic data points could have been included in the linear time series. To use equation (10), let it = $17,169,000 (the mean o f the projected cash flows shown in Table 37), g = 0.05 (to reflect Shattuck Hammond’s 5 percent cash flow growth rate assumption), and i = 0.139 (to reflect the mean of Shattuck Hammond’s 12.6 percent and 152 percent discount rate assumptions). The result is: which is substantially less than Shattuck Hammond’s minimum discounted cash flow value of S310 million. Of course, if k = $23,987,500 (the mean of the projected cash flows for the years 2000 and 2001), the result is which is better yet Other manipulations (since equation (10) has three degrees of freedom, k, g, and i) can produce the “desired” valuation result; e.g., Shattuck Hammond’s minimum value of S310 million. Sharp’s board of directors was prepared to sell the hospital to Columbia/HCA for approximately S228 million (the maximum value of Columbia’s purchase package) but that the California Attorney General objected to the sale because of Shattuck Hammond’s $360 million - $390 million range of hospital enterprise value. The results of equations (9) and (10) suggest that Shattuck Hammond was too optimistic and that, in fact, Columbia/HCA’s offer was not patently unreasonable. $17,169,000 = $192,910,112, 3 n , $23,987,500 = $269,522,472, 0.139-0.05 325 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. B.6 Limitations As previously mentioned, the use of electronic spreadsheets such as Lotus and Excel has greatly facilitated the analyst's ability to project financial statement income and corresponding cash flows.3 * Unfortunately, the assumptions that underlie a valuation analyst’s forecasts or projections are not always clearly stated. In theory, business enterprise valuation should be prospective, not retrospective, because the investor’s locus of concern is supposed to be die present value of the enterprise’s estimated future cash flows. In practice, however, the best forecast of next year’s free cash flow is likely to be a function of the enterprise’s history of free cash flows so that a simple extrapolative (least squares) forecasting model can be used.3 9 In the cases presented, the method of least squares produced simple linear time series functions that, when integrated, produced reasonable valuation results. Using both historic and projected cash flow data should help the valuation analyst to avoid the possibility of intentionally or unintentionally masking or altering disturbing economic trends. The California Attorney General’s valuation consultants used forecasts or projections, but no historical cash flow data. There was no linkage between the consultants’ forecasts or projections and the hospital’s audited financial statements, and in most instances, there was a dearth of audited financial statements. Therefore, I was unable to consider the impact of historic operating cash flows on business enterprise valuation because the hospitals’ cash flow statements prepared in accordance with FASB Statement Nos. 95 and 117 for the five years immediately preceding the acquisitions were, in every instance, missing. 326 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The weak link in determining business enterprise, including hospital, value is ascertaining the enterprise’s post-acquisition cash flows. These flows are, of course, subject to considerable uncertainty because of the impact of regulatory changes, competition, and other economic (exogenous) variables, including consumer behavior. Valuation analysts eschew uncertainty because of its complex mathematics.4 0 Instead, they will usually increase the discount rate to incorporate their subjective beliefs about the variance or dispersion of the enterprise’s prospective cash flows.4 1 A better solution would be for analysts to use spreadsheet simulation models (e.g., Monte Carlo simulation) to treat the uncertainty that is associated with future cash flows.4 2 In none of the reviewed hospital valuation reports was this done. The exercises in this appendix also demonstrate the ability of equations (6) and (10) (the constant growth perpetuity models) to obtain similar business valuation results with considerably less work. More important, the exercises illustrate the opportunities for valuation mischief due to “data mining’’ and “data editing.” Notwithstanding the “scientific appearance” of same advanced practitioner’s textbooks, with their dense mathematical formulas and graphs,4 3 business valuation is subjective and thus it is an art. Rarely, if ever, is it possible to provide anything other than an interval estimate or a range of possible business value. Perhaps this explains why practitioners use all three methodologies (DCF, comparable transactions, and comparable companies) to arrive at a valuation “consensus.” An interesting study would be to examine the actual operating cash flows of the subject hospitals (prepared in accordance with FASB Statement Nos. 95 and 117) for the 327 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. purpose of conducting a “post-acquisition” financial review. Perhaps someone will do this in the not too distant future. 328 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Appendix B 1 Eugene M . Lerner and Willard T. Carleton, A Theory o f Financial Analysis (New Y ork: Harcourt, Brace & World, Inc., 1966), chs. 3,4. 2 Irving Fisher, T h e Theory o f Interest (New York: Macmillan Company, 1930), pp. 1 2 - IS (emphasis in the original). 3 The assumption is that an investor win purchase a prospective business enterprise only if the cost of the investment is less than the present value of die enterprise’ s future income or cash flows. In canonical form, the cost of the investment is incurred once, followed by a sequence of income or cash flows. The economic theory of private investment decisions is similar to that of public investment decisions. Compare Jack Hirshleifer, Investment, Interest, and Capital (Englewood Cliffs, N J: Prentice-H alL, Inc., 1970), with Robert Sugden and Alan W illiams, T he Principles o f Practical Cost-benefit Analysis (Oxford: Oxford University Press, 1978). See also Harold Biennan, Jr. and Seymour Smidt, The Capital Budgeting Decision: Economic Analysis o f Investment Projects. 8* ed. (Upper Saddle River, NJ: Prentice Hall, 1993), and R obin W . Boadway and D avid E . Wildasin, Public Sector Economics, 2— ed. (Boston: Little, B row n and Company, 1984). 4 See Financial Accounting Standards Board Exposure Draft No. 174-B, “Using Cash Flow Information in Accounting Measurements’ * (June 11,1997), 113. 5 See Chancellor Allen’s remarks c m the DCF method in Cede & Co. and Cinerama v . Technicolor, Civil Action No. 7129, Delaware Court of Chancery, 1990 Del. Ch. L EX IS 239 (October 1 9 , 1 9 9 0 ). In the adversarial valuation (litigation) context. Chancellor Allen noted that parties have an incentive “to arrive at estimates of value that are at the outer m argins of plausibility.” B uyers and sellers of business enterprises have similar incentives. 6 See, e.g.. Jack Hirshleifer, Investment. Interest, and Capital (Englewood Cliffs, NJ: Prentice- H aU , Inc., 1970), ch. 2. 7 Stephen G. Kellison, The Theory o f Interest (Homewood, IL: Richard D . Irwin, Inc., 1 9 7 0 ). See also Ernest Brow n Skinner, The Mathematical Theory o f Investment, rev. ed. (Boston: G inn and Company, 1924). 8 Jonathan Barron Baskin and Paul J. Miranti, Jr., A History o f Corporate Finance (Cam bridge: Cambridge University Press, 1997), pp. 119 - 120. See, e.g., Aswath Damodaran, Corporate Finance: Theory and Practice (New York: John Wiley & Sons, Inc., 1997); Stephen A. Ross, Randolph W . Westerfield, and Jeffrey Jaffe, Corporate Finance, 4 ® ed. (Chicago: Irwin, 1996); Richard A. Brealey and Stewart C. M yers, Principles o f Corporate Finance. 5* ed. (New York: The McGraw-Hill Companies, Inc., 1 9 9 6 ); 329 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. William F. Sharpe, Gordon J. Alexander, and Jeffery V. Bailey, Investments. 5* ed. (Englewood Cliffs, NJ: Prentice Hall, 1995); Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 2 * 1 ed. (Homewood, IL : Irwin, 1993); and Thomas E. Copeland and J. Fred Weston, Financial The ory and Corporate Policy, 3- ed. (Reading, M A : Addison-Wesley Publishing Co_ 1988). 1 0 See, e.g.. Shannon P. Pratt, Robert F. Reilly, and Robert P. Schwcihs, Valuing a Business, 4* ed. (New York: McGraw-Hill, 2000); Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing Small Businesses and Professional Practices. 3 * * ed. (N ew York: McGrew Hill, 1 9 9 8 ); Tom Copeland, Tim Roller, and Jack Munin, Valuation: Measuring and Managing die Value of Companies, 2 * d ed. (New York: John Wiley & Sons, 1996); and Aswath Damodaran, Investment Valuation (N ew York: John Wiley & Sons, 1996). 1 1 For the required adjustment, see Simon Z. Benninga and Oded H . Sarig, Corporate Finance: A Valuation Approach (New York: The McGraw-Hill Companies, Inc., 1997), ch. 3. 1 2 See, e.g., John Burr Williams, The Theory o f Investment Va lue (Cambridge, M A : H arvard University Press, 1938), chs. VI and VII, and Robert A. Taggart, Jr., Quantitative Analysis for Investment Management (Upper Saddle River, NJ: Prentice H all, 1996), ch. 4. Although these models were originally developed to price equities (i.e.. com m on stocks), they are equally applicable to free cash (lows for business enterprise valuation purposes. Aswath Dam odaran, Investment Valuation (New York: John W iley & Sons, Inc., 1996), ch. 1 1 . 1 3 See, e.g., R. G . D . Allen, Mathematical Analysis for Economists (London: Macmillan & C o., 1962), pp. 4 0 1 - 404; Walter Nicholson, Microeconomic Theo ry: Basic Principles and Extensions. 5 * ed. (Fort Worth: Dryden Press, 1992), ch. 24. 1 4 For the requisite adjustment, see S. J. N ickeU , The Investment Decisions o f Firms (Cambridge: James Nisbet & Co. and Cambridge University Press, 1978), p. 6, and R. G. D. Allen, Macro- Economic Th eo ry: A Mathematical Treatment (London: M acm illan & Co., 1967), ch. 4. A n important but unresolved issue is whether or not a variable discount rate exerts an important valuation influence. 1 5 See, e.g., T hom as E . Copeland and J. Fred Weston, Financial Theory and Corporate Policy. J * 4 ed. (Reading, M A : Addisoo-Wesiey Publishing Co., 1988), Appendix A. 1 6 See Robert D . Banks, Growth and Diffusion Phenomena: Mathematical Frameworks and Applications (Berlin: Springer-Verlag, 1994), pp. 224 - 240. 1 7 This is com m only referred to as the Gordoo-Shapiro growth model For its derivation, see E zra Solomon, ed., T h e Management o f Corporate Capital (New Y ork: The Free Press, 1959), p p . 1 4 1 - 1 4 9 . 1 8 By using logarithm s, the method of least squares may also be applied to the exponential grow th model 1 9 See Spyros M akridakis, Steven C. Wheelwright, and Rob J. H yndm an, Forecasting: Methods and Applications. 3 "1 ed. (New York: John Wiley & Sons, Inc., 1 9 9 8 ). 330 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2 0 See, e.g.. R evenue Ruling 59-60, 1959-1 Cumulative Bulletin 237 (restating the requirements of the Internal R evenue Service for business valuations for federal estate and gift tax purposes). 2 1 See California Attorney General Press R elease No. 97-044 (April 22,1997). 2 2 The contract price was S5,500,000 cash phis 50% of certain Medicare post-closing payments, less other adjustments. The assets transferred to HeahhSmart Pacific included certain receivables, land, buildings, and personal property (equipment). 2 3 W hen used in text, the ( ) indicates a deficit or a negative cash flow. 2 4 Irving Levin Associates, Inc., The Hospital Acquisition Report, 4* ed. (New Canaan, CT: Irving Levin Associates, 1998), p. 6. 2 5 Ibid. 2 6 For the State of California’s grants, see Calif. Welfare & Inst Code §§ 14085.6, I4105.98(j) (Deering’s 2000). 2 7 In 1989, Q ueen of Angels and Hollywood Presbyterian Medical Center merged. At the time of the merger both nonprofit tax-exempt hospitals were in financial difficulty. Under the terms of the merger agreement the newly formed medical center was required to be operated as a Catholic and Presbyterian religious facility. However, the merger agreement provided that in the event of any dispute the Roman Catholic Archbishop of Los Angeles would have the power to make a final and binding decision. It w as on the basis of this provision in die 1 9 8 9 merger agreement that Cardinal Roger Mahoney had originally argued that the medical center could not be sold to Tenet HealthSystem without his consent, which he told the Attorney General he was unwilling to give because he believed that Catholic religious tenets would be comprom ised by the sale. Subsequently, the Cardinal dropped his opposition to the sale. 2 8 Calif. Corp. C ode § 5914 (Deering’ s 2000). 29 Additional details are contained in Attorney General Dan Lungren’s Fact Sheet, “Report to the Public Regarding the Proposed Sale of Q ueen of Angeies-Hollywood Presbyterian Medical Center to Tenet Healthcare." This feet sheet was issued as part of California Attorney General Press Release N o . 98-069 (May 15,1998). 3 0 To use the mid-year discounting convention, die present value of each year’s cash flow must be multiplied by the square root of one plus the discount rate. If the discount rate rem ains constant over the life of the project, the algebra can be simplified. See Simon Z. Benninga & Oded H. Sarig, Corporate Finance: A Valuation Approach (New York: The McGraw Hill Companies, Inc., 1997). 3 1 I was unable to replicate Arthur Andersen’ s exact figures because there appear to be errors in Arthur Andersen’s mid-year discount rate factors. The differences, however, do not detract from the substance of die analysis. 331 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3 2 I used the arithmetic average of three forecasts for the reasons set forth in Francis X . Diebold and Jose A . Lopez, “Forecast Evaluation and Combination" (Cambridge, MA: National Bureau of Econom ic Research, Technical Working Paper 192, M arch 1996). 3 3 Calif. C orp. Code § S914 (Deering’ s 2000). 3 4 In asset purchase agreements it is common for adjustments to occur as a result of fluctuations in current assets and current liabilities between the date of execution of the asset purchase agreement and the date of closing. Adjustments to the purchase price may be either positive or negative. See Robert R. Tufts, etL , Drafting Agreements for the Sale o f Businesses. 2nd ed. (Berkeley: California Continuing Education of the B ar, 1988). In the final documents, the Attorney General actually increased the purchase price to S72.5 million to take into account other corporate adjustments. 3 5 I recognize that the chi-square test, which 1 did not use, can be used to determine “goodness-of- fit” or h o w well a linear time series of the form ftt) = a +bt actually fits the cash flow projections or data. 3 6 Shattuck H am m ond Partners valued the “put" using a binomial model developed by Cox, Ross, and R ubcnstein in 1979. The Cox et al. model allows the valuation of an American option; Le., an option that gives the holder the right to exercise the option at any time before (and including) the expiration date. See David G. Luenberger, Investment Science (New Y ork: Oxford University Press, 1998), ch. 1 2 . 3 7 See California Attorney General Press Release No. 97-017 (February 21,1997). 3 8 See, e.g., Sim on Benninga, Financial Modeling (Cambridge, M A : The MIT Press, 1997), chs. 1, 2. 3 9 See Gerald I. White, Asbwinpaul C. Sondhi, and D ov Fried, The Analysis and Use of Financial Statements. Y* ed. (New York: John Wiley & Sons, Inc., 1998), ch. 1 9 (discussing both discounted cash flow valuation and forecasting models). 4 0 See A vinash K . Dixit and Robert S. Pindyck, Investment Under Uncertainty (Princeton, N J: Princeton University Press, 1994). 4 1 James C . T . M ao, Quantitative Analysis o f Financial Decisions (Toronto: Collier-Macmillan, 1969), ch. 8 . 4 2 See, e.g., W ayne L. Winston, Simulation Modeling Using @Risk (Belmont, CA: W adsworth Publishing Company, 19%). In simulation, a large number of random paths for possible cash flow sequences (using historic cash flow data or forecasts) would be computer generated and each path's present value would be determined. The average or mean of these paths would represent the best estimate of business enterprise value. In complex models, the analyst could also vary the discount rate. 332 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A more sophisticated M onte Carlo analysis using the mathematics of options appears in Tom Copeland and Vladimir A n tD caro v , Real Options (New York: Texerc, 2001), chs. 9, 1 1 . Although the methodology of “real options" is applicable to business enterprise valuations, sophisticated software w ould appear to be necessary to handle the complex mathematics. The authors do not discuss any such valuation software and none may exist 4 3 See, e.g., Larry J. K asper, Business Valuations: Advanced Topics (Westport, CT: Q uorum Books, 1997). 333 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Appendix C Technical Appendix to Chapter 3: Use o f Charitable Procceeds 334 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Technical Appendix to Chapter 3 Use of Charitable Procceeds C.1 Document Sources This technical appendix presents additional information on the charitable purposes and conversion foundations of the six California hospitals that are the subject of this dissertation. This information was compiled from public records available through the office of the California Attorney General (hospital conversion transaction documents, including articles of incorporation and trust agreements) and financial information available from various websites, including the California Attorney General’s charities database (www.caaa.state.ca.us/chantiesi and GuideStar Pages (www.aujdestar.oml. In addition, several of the hospital conversion foundations maintain their own websites from which financial information, including grant information, is available.1 C.2 Overview As previously mentioned in Chapters 1 and 3, the assets of a nonprofit public benefit corporation are required to remain in charitable solution indefinitely. Thus, when a nonprofit public benefit corporation sells hospital assets (consisting of real and personal property), the sales proceeds (cash and securities) are required to be devoted to a related or similar charitable purpose. The doctrine of cy pres permits a court of competent 335 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. jurisdiction to judicially modify a charitable organization’s governing documents. The Attorney General is required to be a party to any judicial modification or reformation proceeding. With the Attorney General’s approval, the selling nonprofit community hospital corporation may retain the sales proceeds and become a grant-making charitable organization or it may transfer the proceeds to a new or previously existing charitable organization. The term hospital “conversion foundation” is often used to describe the charitable owner or recipient of hospital sales or conversion proceeds.2 In general, a so- called conversion foundation will be an Internal Revenue Code of 1986, § 501 (cX3) tax- exempt “public charity” or tax-exempt “private foundation.” An Internal Revenue Code of 1986, § 501(cX4) tax-exempt “social welfare” organization, though permissible, will be rare or nonexistent For federal income tax purposes, only contributions to Internal Revenue Code § 501(c)(3) organizations are deductible by individual and corporate donors.3 Thus, conversion foundations that are “public charities” or “private foundations” (as opposed to “social welfare” organizations) may continue to receive contributions from public donors. Almost all of the conversion foundations described in this technical appendix are “public charities.” The sole exceptions are the Pacific Hospital of Long Beach Charitable Trust, the successor by merger to Pacific Hospital of Long Beach, and The Healthcare Foundation for Orange County, the transferee of United Western Medical Centers, which have “private foundation” status. None of the conversion foundations studied in this dissertation is a “social welfare” organization. 336 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. C.2.I Go o d Sa m a r it a n He a l t h S yste m On December 13, 1995, the board of directors of die Good Samaritan Health System, which owned and operated die Good Samaritan Hospital o f Santa Oara Valley, agreed to sell the hospital’s assets to Columbia/HCA for approximately $165 million (cash) plus certain post-closing adjustments. The transaction closed in January 19%. After the selling hospital corporation had paid its retained indebtedness, the actual charitable set-aside would be approximately $71 million.4 From the beginning there was controversy regarding the proper use of this amount for charitable purposes. Pursuant to California’s general nonprofit corporation law as it then existed, the hospital was incorporated on April 29, 1960 as “The Good Samaritan Hospital of Santa Clara Valley.'* According to the articles of incorporation,5 The specific and primary purpose for which this corporation is formed is to . . . establish and maintain a hospital for die care of persons suffering from illnesses or disabilities . . . ; to carry on any educational activities related to the rendering of care to the sick and injured or to die promotion of health which, in die opinion of the Board of Trustees may be justified . . . ; to promote and carry on scientific research related to the care of sick and injured persons. . . ; to participate in any activity, so fa r as circumstances may warrant, designed to promote the general health o f the community. [Italics are mine.] I have italicized die last sentence because the language is important: depending upon circumstances, the corporation may act to promote the community’s “general health.” This broad language contributed to die spending controversy. On September 14,1962, the articles of incorporation were amended to provide that in the event of a dissolution of die corporation its “funds and assets” were to be distributed 337 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. to another charitable organisation selected by die hospital's board of directors. On February 2, 1967, the articles were further amended to irrevocably dedicate all corporate property to charitable use. On July 5, 1983, the articles of incorporation were restated in their entirety to comply with the 1980 revisions to the California Corporations Code. The "charitable purposes” language of the original articles, however, was not changed. On October 4 ,198S, a different set of restated articles was filed with the California Secretary of State.6 This time the "charitable purposes” language was changed to read as follows: The specific purposes of this corporation are . . . to provide services for persons who have a variety of health care needs;. . . to carry on any educational activities related to rendering care to the sick and injured or to the promotion of health which, in the opinion of the Trustees, may be justified; and to participate in any activity, so fa r as circumstances may warrant, designed to promote the general health o f the community. [Italics are mine.] The last sentence is the same as the last sentence in the 1960 document Again, the board of directors would be permitted to use corporate assets to promote the community’s "general health.” As the result of various mergers involving affiliated health care organizations, in May 1994 die corporation became known as the "Good Samaritan Health System.” On January 4, 1996, the corporation (operating under die name "Good Samaritan Health System”) sold all of its hospital operating assets to Columbia/HCA Healthcare Corporation for approximately $165 million (cash) plus certain post-closing adjustments. In March 1996, the corporation changed its name to the "Good Samaritan Charitable Trust” After the sale of hospital assets to Columbia/HCA, the corporation continued to absorb by 338 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. merger additional affiliated health care organizations (i-c., organizations that were excluded from the Columbia/HCA transaction). The value of the assets that were absorbed by merger appears to have been approximately $30 million.7 On December IS, 1997, the corporation changed its name to “The Health Trust” At that time, the assets of “The Health Trust” comprised those acquired by merger (approximately $30 million) and the net sales proceeds derived from the 19% Columbia/HCA transaction (approximately $71 million), for total assets (charitable fund) of $101 million. According to the corporation’s restated articles, the corporation may “[ejngage in any lawful activities which promote and enhance the health of the greater Santa Clara County community . . .” This language is not too different from the last sentence (italics) of the corporation’s 1960 articles. Although the Good Samaritan Hospital o f Santa Clara Valley was sold to Columbia/HCA in January 19%, the California Attorney General did not approve the use of the sales proceeds until April 1997.* The corporation’s directors wanted to use the sales proceeds for broad community purposes, consistent with the language (italics) that appears in the corporation’s original 1960 articles. The Attorney General, however, maintained that The Health Trust should be required to follow the hospital's historic pattern of charitable expenditures without regard to the broad language of the hospital’s 1960 articles. The Attorney General’s objections prompted the corporation’s directors to solicit California Senator Kenneth L. Maddy’s intervention. Senator Maddy’s bill, which would have allowed the sales proceeds to be used for broad community benefit purposes without regard to the hospital’s historic pattern of charitable expenditures, died in the Senate. 339 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. It is difficult to understand why the Attorney General objected to the board’s original spending plans. According to the Attorney General, die hospital’s net sales proceeds of approximately S71 million are to be used as follows:9 • $6.9 million to fund community benefit programs; • $103 million to fund school health centers; and • $54.6 million (to be placed in two auxiliary trusts) to provide hospital (approximately $34 million) and outpatient care (approximately $20.6 million) to the medically indigent residents of Santa Clara County. These provisions are extremely broad and the language can embrace almost any pattern of health care expenditure. Because of the complexity of the auxiliary trust documents that were approved by the Attorney General, a compliance audit may be extremely difficult, perhaps impossible. For example, the auxiliary trust documents restrict benefits to the medically indigent residents of certain zip code areas. How well can this restriction be enforced? Individual beneficiaries must also fall within certain federal poverty income guidelines. Can these guidelines be effectively monitored? Thus, it may be difficult to determine whether the directors of The Health Trust are following the Attorney General’s restricted spending guidelines. According to The Health Trust’s website fwww.healthtrustorol. for the year 1998/1999 approximately $3.75 million was given to various nonprofit organizations, including almost $2.0 million to die Santa Clara Valley Health and Hospital System to fund “public health case management services” to uninsured adults and children with 340 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. diabetes or asthma (5971,315) and * 11011) 6 visits” to low income or uninsured pregnant or parenting mothers and their infants (SI,014,621). Another 5749,861 was given to the Stanford Center for Research in Disease Prevention to address the problem of recurring heart disease in low-income residents of Santa Clara Valley. The remainder was spent on a variety of smaller health care programs. The $3.75 million expenditure figure is approximately 5 percent of the 571 million conversion endowment fund, which suggests that the fund’s entire income was spent during die fiscal year.1 0 For the year 1999/2000, The Health Trust’s website discloses that approximately $4 million (slighdy less than 6 percent o f the $71 million net sales proceeds or hospital conversion fund) was given to a variety o f organizations, including: • $1,000,000 to help United Way of Santa Clara County fund health services to its member agencies; • $300,000 to O’Connor Hospital for pediatric services to low-income families; • $625,217 to the Lucile Packard Children’s Hospital to help overweight, low-income children in Santa Clara County; • $450,000 to assist Kaiser Foundation Hospitals and assorted community clinics to provide health care benefits to low-income, mid life women in Santa Clara County; 341 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. • 5547,000 to assist Kaiser Foundation Hospitals and free clinics to provide health care to “very low-income” individuals and families; and • $500,000 to allow the Department of Mental Health, Santa Clara Valley Health and Hospital System, create a care system for “severely mentally ill” young adults. The remainder was spent on a variety of considerably smaller (mean expenditure, approximately $65,000) health care projects. The Attorney General’s attempt to “micromanage” the board’s expenditures is misguided. Circumstances and demographics do change so that die hospital’s historic pattern of charitable expenditures may be a poor guide to the community’s current needs. In addition, given the complexity of the auxiliary trust documents there may be no objective way to determine the proper classification of the board’s actual expenditures. Thus, the Attorney General’s precise spending guidelines may be no better than an expenditure decision made by The Health Trust’s board of directors in the ordinary course of its fiduciary duties. The Health Trust’s website (www.heatthtrust.oral should help interested community residents track grants and other expenditures by die organization’s board of directors. C.2.2 C e n t i n e l a V a l l e y H ea lth S e r v ic e s In August 19%, the Centinela Hospital Medical Center was sold to OrNda Health Corp, a Delaware “for-profit” corporation, for approximately $96.8 million. As the result 342 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of adjustments for liabilities and existing charitable cash on hand (see Technical Appendix, Chapter 2), die hospital sale produced net cash for charitable use of approximately $50 million." The selling corporation (Centinela Valley Health Services, Inc., a California nonprofit public benefit corporation) wanted to have die entire $50 million charitable fond administered by the City of Hope National Medical Center in Duarte, California. The California Attorney General objected because of complaints by local (i.e., Inglewood, California) residents who would be potential beneficiaries: the residents wanted to receive local, not distant health care.1 2 Besides, there was die possibility that the City o f Hope might appropriate funds for its own use and benefit to the detriment of Inglewood residents and beneficiaries. To avoid conflicts of interest and minimize administration expenses, the directors of Centinela Valley Health Services, Inc. decided to transfer the entire $50 million to the California Community Foundation, a nonprofit public benefit corporation that is an umbrella organization which administers restricted and unrestricted charitable funds for die benefit of a specific community or geographic area.1 3 The actual transfer of funds was accomplished by merger, i.e., the existing Centinela nonprofit corporations merged with and into the California Community Foundation. The $50 million fund constitutes a separate, segregated fund within the California Community Foundation (CCF). The funding agreement between Centinela and the CCF provides for a six-member Centinela “advisory board” to make expenditure recommendations to the CCF board. The CCF board, however, is not obligated to follow 343 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. die recommendations of die Centinela advisory board. Indeed, under California law die CCF board must exercise independent judgment The funding agreement between Centinela and CCF contemplates that monies will be used for the following purposes: to provide medical care grants and purchase medical insurance for the benefit of residents of the community that the Centinela Hospital Medical Center had formally served; i.e., residents of Hawthorne, Inglewood, Lawndale, Torrance, and other communities within the “Centinela Valley.” Medical care grants are to be given to qualified nonprofit hospital recipients that can serve Centinela Valley residents; e.g., Cedars-Sinai Medical Center, Daniel Freeman Memorial Hospital, Torrance Memorial Medical Center, and UCLA Medical Center. The funding agreement is devoid of the legal and administrative complexity that appears in the Good Samaritan Health System (The Health Trust) documents. As of this date, no expenditure information is available but approximately $3 million (6 percent of the fund) should be distributable each year.1 4 Additional information appears on CCF's website, www.calfund.orQ. This website should allow interested community residents to track information about grants and expenditures. C.2.3 P acific H o s p i t a l o f L o n g B e a c h The 1996 sale of Pacific Hospital of Long Beach produced the Pacific Hospital of Long Beach Charitable Trust with a charitable endowment of approximately $5.5 million. The old hospital corporation, which was formed on March 16, 1945, merely changed its name to reflect its new status as a grant-making charitable corporation. Unlike the other endowment funds produced by the other hospital conversions, the restated articles of 344 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. incorporation of the Pacific Hospital of Long Beach Charitable Trust specifically state that the trust is to terminate no later than August 31, 2007, at which time all remaining charitable assets are to be distributed to other charitable organizations. This provision exists because it is administratively impractical to manage a small endowment fund. Over the next seven years, the entire fund (principal and income) will be distributed to other charitable organizations. As one would expect, the directors of the charitable trust are required to make grants to organizations to benefit indigent individuals who reside within the City of Long Beach. According to the restated articles of incorporation, not more than 10 percent is to be devoted to osteopathic medical education purposes; not more than 43.5 percent is to be devoted to outpatient care purposes; and not less than 46.5 percent is to be devoted to inpatient care purposes. Given the relatively small size of the endowment fund it is highly unlikely that any grants will attract public scrutiny or regulatory attention. No website was found and no financial information was available. C.2.4 U n it e d W e s t e r n M e d ic a l C e n t e r s In December 1996, United Western Medical Centers (UWMC), a California nonprofit public benefit corporation, sold certain hospital facilities to a subsidiary of OrNda Healthcare, which is now Tenet Although the sales price was approximately $177 million, 1 5 the net cash to the nonprofit seller amounted to only $132 million.1 6 The Attorney General-approved successor charitable organization. The Healthcare Foundation for Orange County, received approximately $20 million.1 7 345 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. According to the Healthcare Foundation’s 1994 restated articles of incorporation, the corporation’s charitable purpose is to “promote and support health care for the benefit of the community in the County of Orange’ * by supporting hospitals, clinics, and other health facilities. The Healthcare Foundation’s articles are not extremely complicated and thus the Foundation’s board of directors has considerable spending discretion regarding charitable activities. For federal income tax purposes, the corporation is a “private foundation’ ’ and not a “public charity.” Accordingly, The Healthcare Foundation’s website materials (www.hfbc.oral indicate that each fiscal year the board of directors is committed to distributing 5 percent of the corporation’s net assets (approximately SI million) to qualifying Orange County public charities. This S percent figure happens to be the “minimum investment return” (i.e., the minimum required distribution) that is specified in the federal income tax law for private foundations.1 8 The website’s materials indicate that management’ s targeted investment return is 9.4 percent per annum. The website’s materials list partial grants for the last two fiscal years. The largest grant went to Anaheim Memorial Medical Center ($595,623) to support the education of ethnic minority health care workers (e.g., medical technologists and nurses). The next largest grant went to Children’s Hospital of Orange County ($335,000) to fund family primary care services and create a children’s clinic. The Healthcare Foundation’s website contains links to the websites of various grantees, which should make it easy for interested community residents to obtain additional information. 346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. C .2.5 Q u e e n o f A n g e l s In December 1997, the directors of Queen of Angels—Hollywood Presbyterian Medical Center agreed to sell die hospital to Tenet for a purchase price of approximately $131.7 million. As the result of a large previously existing hospital endowment fond, following the sale the total funds available for charitable use would be approximately $277 million. On September 17, 1936, Hollywood Hospital was incorporated in California as a corporation “which does not contemplate pecuniary gain or profit to the members thereof." The articles of incorporation state the corporation’s purposes are to:1 9 [A]cquire, own, lease, build, maintain and/or operate hospitals, sanitariums and/or infirmaries; . . . and to do every act that is necessary in connection with the operation and conducting of the hospital business . . . In 1953, the corporation changed its name to “Hollywood Presbyterian Hospital.” In 1959, the name was changed to “Hollywood Presbyterian Hospital-OImsted Memorial” and the corporation’s powers were expanded to permit the corporation to:2 0 [EJstablish, maintain, conduct and operate hospitals, sanitaria, asylums, rest or retirement homes, maternity homes, dispensaries, clinics and places and institutions for the care and treatment of the sick, afflicted and aged and to furnish and supply care, treatment, hospitalization and other services therein with or without compensation therefor,... The 1959 amendments also placed die hospital facility under the direction and control of the “Presbytery of Los Angeles” and its successor in interest 347 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In February 1989, die hospital corporation acquired the Queen of Angels hospital facility it became known as “Queen of Angels—Hollywood Presbyterian Medical Center.’ ' Although die articles of incorporation were restated and the restated articles reflect the same charitable purposes, the restated articles require the corporation to carry out its mission “in compliance with die Ethical and Religious Directives for Catholic Health Facilities promulgated by the National Council of Catholic Bishops.” Thus, when the corporation acquired Queen of Angels in 1989, it became a Catholic healthcare institution. Additional amendments were made in 1 9 9 1 and May1998, and both times die articles o f incorporation were restated in their entirety. The May 1998 restatement, which appears to have been made concurrently with die sale of the hospital facility to Tenet Healthcare for approximately $132 million, does not contain the previous requirement that the corporation carry out its mission in compliance with Catholic healthcare guidelines. Instead, the May 1998 restatement states that the hospital may not perform certain procedures, including abortions, unless the health of a pregnant woman is at stake. Interestingly, the sole member o f the corporation, the thus the person with the legal right to vote for the corporation’s directors and decide other matters of importance, is S t Joseph’s Health Support Alliance, a California nonprofit public benefit corporation. In June 1998, the articles were again amended and restated. The corporation’s name was changed to “QueensCare,” and its principal purpose was changed to administering the corporation’s “Investment Fund.” The $277 million Investment Fund includes the corporation’s previously accumulated endowment fund (approximately $167 million) and the net proceeds derived from the sale of the hospital facility to Tenet (approximately $110 million).2 1 348 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. According to the restated articles, which are extremely complex, there are 13 sub funds within the $277 million “Investment Fund”:2 2 1 . An inpatient healthcare fund of $101 million; 2. An outpatient healthcare fund of $29 million; 3. An emergency medical services fund of S30 million; 4. A “Greater Hollywood Health Partnership Fund” of SIS million; 5. A Franciscan Clinics fund of S32 million; 6. A pastoral care services fund of $5 million; 7. A transportation fund of $5 million; 8. A bilingual access and translation fund of $10 million; 9. A discretionary grants fund of S7.5 million; 10. An AIDS fund of $2 million; 11. A restricted gifts fund (to accommodate previously restricted gifts) of$l million; 12. An education and outreach fund of S10 million; and 13. A residual, discretionary fund of approximately S29 million (representing the difference between the total investment fund of S277 million and the previous 12 previous sub-funds). 349 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Many of these sub-funds are discussed in die Attorney General’s press release that was issued during die hospital conversion approval process.2 3 According to QueensCare’s June IS, 1998 articles of incorporation, these categories may not be changed unless there is ic y pres proceeding in the superior court to which the Attorney General is a party. The QueensCare website fwww.aueenscafe.com) contains a list of charitable grants for the fiscal years 1998 (approximately S3 million, or 1 percent of the Investment Fund) and 1999 (approximately S16 million, or almost 6 percent of the Investment Fund). I would expect die start-up grants (1998 was the first year) to be low. For 1999, however, it would appear that QueensCare distributed all or substantially all of the income from the Investment Fund. Unfortunately, the grants, as disclosed on QueensCare’s website, are not linked to any of the thirteen permissible expenditure or sub-fund categories, although I suspect an independent auditor could trace each grant to a specific sub-fund. Whether or not the Attorney General will require an audit report or engage die services of an outside consultant to monitor QueensCare’s expenditures remains to be seen. The larger problem is that QueensCare’s board of directors may not change the expenditure categories without the Attorney General’s consent, even if operating adjustments become necessary. The Attorney General’s “micro-management” of the charitable corporation’s expenditures would seem to be excessive. Perhaps even more troubling is the inclusion of the selling hospital’s previously accumulated endowment fund (approximately SI67 million) in the restricted “Investment Fund.” When donors were contributing to this fund, I believe they thought that the hospital 350 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. corporation’s board o f directors would use their donations for general charitable purposes. I think the entire balance of the previously accumulated endowment fund (SI67 million) should have been placed in the residual, discretionary fund. However, this was not done. The QueensCare website fwww.Queetiscare.com) contains considerable information about the charitable organization, its board of directors, and its grant-making activities. There is also an “on-line” application form for grant-seeking charitable organizations. C.2.6 R ive rsid e C o m m u n it y H o s p i t a l In 1997, Riverside Community Hospital was sold to Columbia/HCA for approximately S71 million in cash and securities, including a 25 percent interest in a joint venture “for-profit” company that would own and operate die acquired hospital.2 4 Because of purchase adjustments and pre-existing hospital indebtedness that the seller was required to extinguish, cash available for charitable use (the required charitable set-aside or hospital conversion endowment) amounted to only $21 million (approximately).2 3 Almost immediately, and because of the asset sale, the selling nonprofit hospital corporation and certain of its nonprofit affiliates were merged into Community Health Corporation (CHC), a previously existing nonprofit public benefit parent corporation (since 1985). Thus, the surviving corporation and the owner of trust fund assets, including all cash and securities proceeds from the 1997 hospital sale, is CHC.2 6 Community Health Corporation’s 1985 articles o f incorporation reflect the following charitable purpose: “[Tjo own, operate and manage a health care system, consisting of charitable hospitals and related health programs, in the County of Riverside, and surrounding areas in the State of California.”2 7 Under that language, CHC was 351 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. required to own and operate a hospital but, because of the 1997 asset sale, there would be no hospital to operate or manage. Although CHC would own a 25 percent equity interest in the “for-profit” purchaser of Riverside Community Hospital, that interest would not give CHC effective control over hospital activities. Besides, CHC has the right, exercisable at any time, to require Columbia/HCA to purchase its 25 percent equity interest The Attorney General required this “put” as a condition to approving the hospital sale. Under the doctrine of cy pres, the superior court would have to permit the 1985 articles to be amended to reflect a different but related or similar charitable purpose. Under California’s hospital conversion law, the Attorney General would have to devise a plan that would permit the hospital sales proceeds to be used “consistent with the charitable trust on which the assets [were] held” by the selling nonprofit hospital corporation.2 8 The Attorney General and CHC were able to determine that Riverside Community Hospital had been providing three categories of health care: (1) in-patient care, (2) out-patient care, and (3) health and medical education. Accordingly, it was decided that CHC’s 1985 articles should be amended to reflect the hospital’s historical proportions of health care activities: 55 percent, 42.5 percent, and 2.5 percent, respectively. In May 1997, CHC’s articles of incorporation were amended to permit the corporation to “operate or support,” “directly or indirectly,” hospitals, clinics, and other health care activities. In addition, not less than 55 percent of CHC’s charitable expenditures could be made for in-patient indigent care, not more than 42.5 percent could be made for out-patient indigent care, and not more than 2.5 percent could be made for educational purposes. In July 1999 and again in October 1999, additional amendments 352 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. were made to CHC’s corporate articles. The October 1999 amendment states that the written approval of the Attorney General is required for any subsequent changes. CHC’s website (w w w .rdTf.oral discloses balance sheet and income statement information from Internal Revenue Service Form 990 as well as its total grants for 1999 ($895,550) and 2000 ($853,965). There were 15 grants in 1999 and 14 grants in 2000. Most of the grants were made to other tax-exempt charitable medical centers in Riverside County and, consistent with the Attorney General’s spending requirements, the grants indicate that they were made for in-patient indigent care, out-patient indigent care, or medical education purposes. The largest grant ($400,000 in 1999) was made to the Riverside County Health Services Agency to fund an out-patient center for indigent families. The next largest grant ($375,000 in 2000) was made to the Riverside County Regional Medical Center to fund in-patient indigent care. Using a rate of return of 5 percent, the $21 million endowment fund should produce an annual income of approximately $1 million. Thus, it would appear that CHC is spending substantially all of its annual investment income. In addition, the CHC website reports that CHC received a $250,000 distribution from its 25 percent equity interest in the limited liability company that owns and operates Riverside Community Hospital. Distributions from the joint venture hospital company constitute additional sources of distributable cash for grant-making purposes. C.3 Comments and Conclusion With the exception of the Pacific Hospital of Long Beach Charitable Trust, the successor-in-interest to Pacific Hospital of Long Beach, information about each of the 353 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. hospital conversion foundations was available from a specific website. I was unable to find a website that contained any information about the Pacific Hospital of Long Beach conversion. Although basic contact information is available from each website, the websites of some conversion foundations provide more financial and grant information than others. A uniform reporting and disclosure format would be helpful to enable interested persons to track the conversion proceeds and the resultant grants. In theory, the California Attorney General’s charities database (www.caao.state.ca.us/charitiesl contains Internal Revenue Service Form 990 financial information for every charitable organization that is required to report on an annual basis to the Attorney General’s Registry of Charitable Trusts. Conversion foundations (but not nonprofit hospitals) are required to report In practice, however, the Attorney General’s website is difficult to use because the conversion foundation’s legal name or tax identification number must be known. Moreover, due to budget constraints the website is not as current as it needs to be. For conversion foundations (and other charitable organizations) that do choose to post information on their own websites, the Attorney General could publish a recommended reporting format to facilitate the disclosure of important information to the public. Useful items of information would include: • The organization’s proper legal name, address, and telephone number, • The organization’s directors and officers; • The organization’s public contact officer, if any; 354 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. • Management's short discussion of die current year’s activities and results of operation, including information about major grants; • An abstract or synopsis of die organization’s charitable purposes from its governing document; and • The organization’s current financial statements (balance sheet, income statement, and statement of cash flows); Management’s short discussion of the organization’s current activities and results of operations should focus on material items that could impact the community and potential or known charitable beneficiaries. For public companies, the Securities and Exchange Commission requires a similar discussion because the information is deemed relevant to investors’ decision-making.2 9 For public charities that solicit contributions from the private sector, the information is no less important Eventually, every charitable organization with assets of more than, say $10 million, should be required to have a website that contains the above information. Mandatory Internet “cyber-accountability” as a tool for exposing abuse, misuse, and corruption by nonprofit organizations is an idea whose time has come.3 0 355 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Endnotes for Appendix C A timely Internal Revenue Service Form 990 was unavailable for every selling hospital or hospital conversion organization. Both the California Attorney General’ s website and the GuideStar Pages contain significant gaps. 2 James M . Ferris and Marcia K . Sharp. “California Foundations: A Snapshot,” The Center on Philanthropy and Public Policy, University of Southern California, February 2001, p. 7. 3 See Internal Revenue Code of 1 9 8 6 , § 170. Charitable contributions to “private foundations” are deductible but subject to special restrictions. In addition, “private foundations” are subject to special operating rules and federal excise taxes in die event of noncotnpliance. 4 The Attorney General’s press release refers to $71.8 million in charitable funds. S ee California Attorney General Press Release N o. 97-044 (April 22, 1 9 9 7 ). Any difference due to rounding is immaterial. 5 Document or Corporate No. 39S436, filed April 29, 1960, in the Office of the Secretary of State of the State of California. 6 Document or Amendment No. A 30S63S, filed October 4, 1 9 8 5 , in the Office of the Secretary of State of the State of California. 7 According to GuideStar’s review of Internal Revenue Service Form 990, at July I, 1997 the assets of the G ood Samaritan Charitable Trust amounted to S101 million. If this figure is correct, and if the 1996 asset sale to Columbia/HCA was worth S 71 million (Le., the cash price of approximately S165 million less the selling hospital corporation’s retained indebtedness), then $30 million m ust be the value of the assets acquired by m erger. See w w w am destar o m . 8 See California Attorney General Press Release No. 97-044 (April 22,1997). Ibid. There is an immaterial discrepancy between die figures contained in the Attorney General’s press release and the amounts actually mentioned in die relevant docum ents of The Health Trust 1 0 According to GuidcStar’s analysis of Internal Revenue Service Form 990, for the year ended June 30, 19 9 8 , gross revenue amounted to $14.2 million of which investment incom e was $43 million. See v»ww.otJidestar.ofo. 1 1 This $50 million figure is almost identical to die amount (S52.7million) that was reported by Centinela Valley Health Services on its Internal Revenue Service Form 990 for the hospital’s 1998 fiscal year. For financial information, see www.ouidestar.ora. 356 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 2 Ron Shinkman, “Keep the M oney Local: Calif. AG Tells New Charitable Trust to Revise P la n s ,* * Modem Healthcare, October 27,1997, p. 22. 1 3 See generally 26 Code of Federal Regulations § 1.170A-9(e)10 (2000). 1 4 According to GuideStar’ s review of Internal Revenue Service Form 990, for the fiscal year ended June 30, 1998, the fund earned investment income of approximately S 2 .8 million. See w w w .q u id e s ta r.o rQ . 1 3 Consumers Union reported the sales price to be $185 million. See Julio Mateo and Jaime Rossi, “White Knights or Trojan H orses? A Policy and Legal Framework for Evaluating Hospital Consolidations in California” (San Francisco: Consumers Union, April 1999), Table 4, available at w w w .c o n s u m e fs u n io n .o fQ . (Hereafter cited as Mateo and Rossi.) The difference is immaterial and it is probably due to an excluded nursing home asset 1 6 The gross purchase or sales price of $177 million must be reduced by the liabilities that were assumed by the purchaser (approximately $45 million). See Appendix B (Technical Appendix for Chapter 2) for additional accounting details. 1 7 See the Foundation’ s website at w w w .h fa c .o m . The Foundation’s March 31, 2000 balance sheet shows total assets of approximately $21 million. According to my computation shown in Appendix B (Technical A ppendix for Chapter 2), the Foundation should have received more than $40 million. The funding difference may be attributable to changes in the selling hospital’s patient receivables and current liabilities at the time of closing. These changes would reduce the net cash available for charitable use. 1 8 See Internal Revenue Code of 1 9 8 6 , § 4942(e). 1 9 Document or Corporate No. 168 4 5 1 , filed September 17, 1936, in the Office of the Secretary of State of the State of California. 2 0 Document or Amendment N o. A2011 5 , filed December 15, 1959, in the Office of the Secretary of State of the State of California. 2 1 Documents in the Attorney General’s public file indicate that immediately after the sale of the hospital facility to Tenet die corporation’s endowment fund balance would be approximately $2 8 1 million. Of this amount, approximately $249 million was in cash or cash equivalents and the remainder represented retained patient and other receivables, which Tenet did not purchase. These receivables amounted to approximately $ 3 1 million. The Attorney General reported that the sale would net the selling hospital $272 million in charitable funds. See California Attorney General’s Press Release No. 98-069 (May 15,1998). Consumers Union reported the charitable endowment to be $277 million. The accounting differences are immaterial and they are undoubtedly due to purchase price adjustments. Another way to arrive at the post-closing fim d balance is to add the consideration for Tenet’s purchase of approximately $132 million to the hospital's pre-existing endowment fund balance of approximately $167 million. Although the total ($299 million) exceeds other reported 357 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. endowment fund balances, tbe unexplained discrepancy (approximately S20 million) is probably due to unreported purchase price adjustments and tbe corporation’s retained liabilities. 2 2 I am unable to reconcile tbe $277 million investment or endowment fund amount with tbe $400 million figure that was reported by Grantmakers in Health in its March 2001 report, “A Profile of New Health Foundations,'' available at ww.ah.nm. This $400 million figure also appears in GuideS tar, w w w .o u id e s ia r.o m . for “Queen of Angels Hollywood Presbyterian Medical Center.” 2 3 California Attorney General Press Release No. 98-066 (May 4,1998). 2 4 See w w w .rc h c .o m . See also California Attorney General Press Release No. 97-043 (April 22, 1997).). 2 5 The accounting details are contained in Appendix B (Technical Appendix to Chapter 2). This $21 million figure is consistent with the charitable set-aside that shown in tbe Consumers U nion 1999 report See Mateo and Rossi, Table 6. 2 6 The Community Health Corporation’ s w ebsite, w w w .rc h f.o m contains some financial information. According to Internal Revenue Service Form 990, for the fiscal year ended December 31, 1999 Community Health Corporation had assets of approximately $47 million. Unfortunately, the nature of those assets is unclear. For that same fiscal year, tbe corporation’s investment income was reported to have been approximately $4 million. 2 7 Document or Corporate No. 1336823, filed April 12,1985, in the Office of the Secretary of State of the State of California. 2 8 See Calif. Corp. Code § § 5917,5923 (Deering’ s 2000). 2 9 See 1 7 Code of Federal Regulations § 229.303 (2000). 3 0 See Peter Swords, “Tbe Form 990 As An Accountability Tool for 501(c)(3) Nonprofits,” 51(3) Tax Lawyer 571 - 618 (Spring 1998). 358 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
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Creator
Heller, Richard George
(author)
Core Title
Hospital conversions: The California experience
School
Graduate School
Degree
Doctor of Philosophy
Degree Program
Public Administration
Publisher
University of Southern California
(original),
University of Southern California. Libraries
(digital)
Tag
OAI-PMH Harvest,Political Science, public administration
Language
English
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Digitized by ProQuest
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Ferris, James M. (
committee chair
), Graddy, Elizabeth (
committee member
), Sacker, Robert (
committee member
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194437
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